CPC 33 (R1) - Correlação às Normas Internacionais de Contabilidade – IAS 19 (IASB - BV 2012)
Benefícios a Empregados
Correlação às Normas Internacionais de Contabilidade – IAS 19 (IASB - BV 2012)
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Sumário
OBJETIVO
ALCANCE
DEFINIÇÕES
BENEFÍCIOS DE CURTO PRAZO AOS EMPREGADOS
Reconhecimento e mensuração
Todos os benefícios de curto prazo aos empregados
Licenças remuneradas de curto prazo
Planos de participação nos lucros e bônus
Divulgação
BENEFÍCIOS PÓS-EMPREGO: DISTINÇÃO ENTRE PLANOS DE
CONTRIBUIÇÃO DEFINIDA E PLANOS DE BENEFÍCIO DEFINIDO
Planos multiempregadores
Planos de beneficio definido que compartilham riscos entre as várias entidades sob
controle comum
Planos de previdência social (planos públicos)
Seguro de Benefícios
BENEFÍCIOS PÓS-EMPREGO: PLANOS DE CONTRIBUIÇÃO DEFINIDA
Reconhecimento e mensuração
Divulgação
BENEFÍCIOS PÓS-EMPREGO: PLANOS DE BENEFÍCIO DEFINIDO
Reconhecimento e mensuração
Item
1
2 – 7
8
9 – 25
11 – 24
11 – 12
13 – 18
19 – 24
25
26 – 49
32 – 39
40 – 42
43 – 45
46 – 49
50 – 54
51 – 52
53 – 54
55 – 152
56 – 60
CPC_33(R1)_Rev_21
Contabilização da obrigação construtiva
Balanço patrimonial
Reconhecimento e mensuração: valor presente de obrigação por beneficio definido e
custo do serviço corrente
Método de avaliação atuarial
Atribuição de beneficio a períodos de serviço
Premissas atuariais
Premissas atuariais: mortalidade
Premissas atuariais: taxa de desconto
Premissas atuariais: salários, benefícios e custos médicos
Custo do serviço passado e ganhos e perdas na liquidação (settlement)
Custo do serviço passado
Ganhos e perdas na liquidação
Reconhecimento e mensuração: ativos do plano
Valor justo dos ativos do plano
Reembolsos
Componentes de custo de benefício definido
Juros líquidos sobre o valor líquido de passivo (ativo) de benefício definido
Remensurações do valor líquido de passivo (ativo) de benefício definido líquido
Apresentação
Compensação
Distinção entre circulante e não circulante
Componente financeiro de custo de benefício definido
Divulgação
Características dos planos de benefício definido e riscos a eles associados
Explicação de valores das demonstrações contábeis
Montante, prazo e incerteza de fluxos de caixa futuros
Planos multiempregadores
Planos de benefício definido que compartilham riscos entre várias entidades sob controle
comum
Requisitos de divulgação em outros Pronunciamentos
OUTROS BENEFÍCIOS DE LONGO PRAZO A EMPREGADOS
Reconhecimento e mensuração
Divulgação
BENEFÍCIOS RESCISÓRIOS
61 – 62
63 – 65
66 – 98
67 – 69
70 – 74
75 – 80
81 – 82
83 – 86
87 – 98
99 – 112
102 – 108
109 – 112
113 – 119
113 – 115
116 – 119
120 – 130
123 – 126
127 – 130
131 – 134
131 – 132
133
134
135 – 152
139
140 – 144
145 – 147
148
149 – 150
151 – 152
153 – 158
155 – 157
158
159 – 171
CPC_33(R1)_Rev_21
Reconhecimento
Mensuração
Divulgação
DISPOSIÇÕES TRANSITÓRIAS
Objetivo
165 – 168
169 – 170
171
172 – 174
1. O objetivo deste Pronunciamento é estabelecer a contabilização e a divulgação dos benefícios
concedidos aos empregados. Para tanto, este Pronunciamento requer que a entidade
reconheça:
(a) um passivo quando o empregado prestou o serviço em troca de benefícios a serem pagos
no futuro; e
(b) uma despesa quando a entidade se utiliza do benefício econômico proveniente do serviço
recebido do empregado em troca de benefícios a esse empregado.
Alcance
2.
3.
Este Pronunciamento deve ser aplicado pela entidade empregadora/patrocinadora na
contabilização de todos os benefícios concedidos a empregados, exceto aqueles para os quais
se aplica o Pronunciamento Técnico CPC 10 – Pagamento Baseado em Ações.
Este Pronunciamento não trata das demonstrações contábeis elaboradas pelos planos de
benefícios a empregados ou pelos fundos de pensão e assemelhados.
4. Os benefícios a empregados aos quais este Pronunciamento se aplica incluem aqueles
proporcionados:
(a) por planos ou acordos formais entre a entidade e os empregados individuais, grupos de
empregados ou seus representantes;
(b) por disposições legais, ou por meio de acordos setoriais, pelos quais se exige que as
entidades contribuam para planos nacionais, estatais, setoriais ou outros; ou
(c) por práticas informais que deem origem a uma obrigação construtiva (ou obrigação não
formalizada, conforme Pronunciamento Técnico CPC 25 – Provisões, Passivos
Contingentes e Ativos Contingentes). Práticas informais dão origem a uma obrigação
construtiva quando a entidade não tiver alternativa senão pagar os benefícios. Pode-se
citar, como exemplo de obrigação construtiva, a situação em que uma alteração nas
práticas informais da entidade cause dano inaceitável no seu relacionamento com os
empregados.
5. Os benefícios a empregados incluem:
(a) benefícios de curto prazo a empregados, como, por exemplo, os seguintes, desde que se
espere que sejam integralmente liquidados em até doze meses após o período a que se
referem as demonstrações contábeis em que os empregados prestarem os respectivos
serviços:
CPC_33(R1)_Rev_21
(i) ordenados, salários e contribuições para a seguridade social;
(ii) licença anual remunerada e licença médica remunerada;
(iii) participação nos lucros e bônus; e
(iv) benefícios não monetários (tais como assistência médica, moradia, carros e bens ou
serviços gratuitos ou subsidiados) para empregados atuais;
(b) benefícios pós-emprego, como, por exemplo, os seguintes:
(i) benefícios de aposentadoria (por exemplo, pensões e pagamentos integrais por
ocasião da aposentadoria); e
(ii) outros benefícios pós-emprego, tais como seguro de vida e assistência médica pós-
emprego;
(c) outros benefícios de longo prazo aos empregados, tais como:
(i) ausências remuneradas de longo prazo, tais como licenças por tempo de serviço ou
sabáticas;
(ii) jubileu ou outros benefícios por tempo de serviço; e
(iii) benefícios por invalidez de longo prazo;
(d) benefícios rescisórios.
6. Os benefícios a empregados incluem os benefícios oferecidos tanto aos empregados quanto
aos seus dependentes e que podem ser liquidados por meio de pagamentos (ou fornecimento
de bens e serviços) feitos diretamente a empregados, seus cônjuges, filhos ou outros
dependentes ou ainda por terceiros, como, por exemplo, entidades de seguro.
7. O empregado pode prestar serviços a uma entidade em período integral, parcial, permanente,
casual ou temporariamente. Para os fins deste Pronunciamento, a definição de empregado
também inclui diretores e outros administradores.
Definições
8. Os termos a seguir são usados neste Pronunciamento com os seguintes significados:
Definição de benefícios a empregados
Benefícios a empregados são todas as formas de compensação proporcionadas pela entidade
em troca de serviços prestados pelos seus empregados ou pela rescisão do contrato de
trabalho.
Benefícios de curto prazo a empregados são benefícios (exceto benefícios rescisórios) que se
espera que sejam integralmente liquidados em até doze meses após o período a que se referem
as demonstrações contábeis em que os empregados prestarem o respectivo serviço.
Benefícios pós-emprego são os benefícios a empregados (exceto benefícios rescisórios e
benefícios de curto prazo a empregados), que serão pagos após o período de emprego.
CPC_33(R1)_Rev_21
Outros benefícios de longo prazo aos empregados são todos os benefícios aos empregados
que não benefícios de curto prazo aos empregados, benefícios pós-emprego e benefícios
rescisórios.
Benefícios rescisórios são benefícios aos empregados fornecidos pela rescisão do contrato de
trabalho de empregado como resultado de:
(a) decisão da entidade terminar o vínculo empregatício do empregado antes da data normal
de aposentadoria; ou
(b) decisão do empregado de aceitar uma oferta de benefícios em troca da rescisão do
contrato de trabalho.
Definições relativas à classificação de planos
Planos de benefícios pós-emprego são acordos formais ou informais nos quais a entidade se
compromete a proporcionar benefícios pós-emprego a um ou mais empregados.
Planos de contribuição definida são planos de benefícios pós-emprego nos quais a entidade
patrocinadora paga contribuições fixas a uma entidade separada (fundo), não tendo nenhuma
obrigação legal ou construtiva de pagar contribuições adicionais se o fundo não possuir ativos
suficientes para pagar todos os benefícios aos empregados relativamente aos seus serviços do
período corrente e anterior.
Planos de benefício definido são planos de benefícios pós-emprego que não sejam planos de
contribuição definida.
Planos multiempregadores são planos de contribuição definida (exceto planos de previdência
social) ou planos de benefício definido (exceto planos de previdência social) que:
(a) possuem ativos formados por contribuições de várias entidades patrocinadoras que não
estão sob o mesmo controle acionário; e
(b) utilizam aqueles ativos para fornecer benefícios a empregados a mais de uma entidade
patrocinadora, de forma que os níveis de contribuição e benefício sejam determinados
sem identificar a entidade patrocinadora que emprega os empregados em questão.
Definições relativas ao valor líquido de passivo (ativo) de benefício definido líquido
Valor líquido de passivo (ativo) de benefício definido é o déficit ou superávit, ajustado para
refletir qualquer efeito da limitação de valor líquido de ativo de benefício definido ao teto de
ativo (asset ceiling) para reconhecimento.
Déficit ou superávit é:
(a) o valor presente da obrigação de benefício definido; menos
(b) o valor justo dos ativos do plano (se houver).
Teto de ativo (asset ceiling) é o valor presente de quaisquer benefícios econômicos
disponíveis na forma de restituições provenientes do plano ou de reduções nas contribuições
futuras para o plano.
CPC_33(R1)_Rev_21
Valor presente de obrigação de benefício definido é o valor presente sem a dedução de
quaisquer ativos do plano, dos pagamentos futuros esperados necessários para liquidar a
obrigação resultante do serviço do empregado nos períodos corrente e passados.
Ativos do plano compreendem:
(a) ativos mantidos por fundo de benefícios de longo prazo a empregados; e
(b) apólices de seguro elegíveis.
Ativos mantidos por fundo de benefícios de longo prazo aos empregados são ativos (exceto os
instrumentos financeiros intransferíveis emitidos pela entidade patrocinadora) que:
(a) são mantidos pela entidade (fundo) legalmente separada da entidade patrocinadora e que
existem exclusivamente para pagar ou custear benefícios aos empregados; e
(b) estão disponíveis para serem utilizados somente para pagar ou custear benefícios aos
empregados, não se encontram disponíveis para os credores da entidade patrocinadora
(mesmo em caso de falência ou recuperação judicial) e não podem ser devolvidos à
entidade patrocinadora, a menos que:
(i) os ativos do fundo forem suficientes para o cumprimento de todas as obrigações de
benefícios aos empregados do plano ou da entidade patrocinadora; ou
(ii) os ativos forem devolvidos à entidade patrocinadora com o intuito de reembolsá-la
por benefícios já pagos a empregados.
Apólice de seguro elegível é a apólice de seguro1 emitida por seguradora que não seja parte
relacionada (como definido no Pronunciamento Técnico CPC 05 – Divulgação sobre Partes
Relacionadas) da entidade patrocinadora, se o produto da apólice:
(a) só puder ser utilizado para pagar ou custear benefícios a empregados, segundo um plano
de benefício definido; e
(b) não esteja disponível para os credores da própria entidade patrocinadora (mesmo em caso
de falência) e não possa ser pago a essa, a menos que:
(i) o produto represente ativos excedentes que não sejam necessários para a apólice
cobrir todas as respectivas obrigações de benefícios a empregados; ou
(ii) o produto seja devolvido à entidade patrocinadora para reembolsá-la por benefícios a
empregados já pagos.
Valor justo é o preço que seria recebido pela venda de um ativo ou que seria pago pela
transferência de um passivo em uma transação não forçada entre participantes do
mercado na data da mensuração.
Definições relativas ao custo de benefício definido
Custo do serviço compreende:
1 Apólice de seguro elegível não necessariamente é um contrato de seguro, conforme definido no Pronunciamento Técnico
CPC 11 – Contratos de Seguro.
¹ Uma apólice de seguro qualificada não necessariamente é um contrato de seguro, conforme definido pelo Pronunciamento
Técnico CPC 50 – Contratos de Seguro. (Alterada pela Revisão de Pronunciamentos Técnicos n.º 21)
CPC_33(R1)_Rev_21
(a) custo do serviço corrente, que é o aumento no valor presente da obrigação de benefício
definido resultante do serviço prestado pelo empregado no período corrente;
(b) custo do serviço passado, que é a variação no valor presente da obrigação de benefício
definido por serviço prestado por empregados em períodos anteriores, resultante de
alteração (introdução, mudanças ou o cancelamento de um plano de benefício definido)
ou de redução (uma redução significativa, pela entidade, no número de empregados
cobertos por um plano); e
(c) qualquer ganho ou perda na liquidação (settlement).
Juros líquidos sobre o valor líquido de passivo (ativo) de benefício definido é a mudança,
durante o período, no valor líquido de passivo (ativo) de benefício definido resultante da
passagem do tempo.
Remensurações do valor líquido de passivo (ativo) de benefício definido compreendem:
(a) ganhos e perdas atuariais;
(b) retorno sobre os ativos do plano, excluindo valores incluídos nos juros líquidos sobre o
valor líquido de passivo (ativo) de benefício definido; e
(c) qualquer mudança no efeito do teto de ativo (asset ceiling), excluindo valores incluídos
nos juros líquidos sobre o valor líquido de passivo (ativo) de benefício definido.
Ganhos e perdas atuariais são mudanças no valor presente da obrigação de benefício definido
resultantes de:
(a) ajustes pela experiência (efeitos das diferenças entre as premissas atuariais adotadas e o
que efetivamente ocorreu); e
(b) efeitos das mudanças nas premissas atuariais.
Retorno sobre os ativos do plano consiste em juros, dividendos e outras receitas derivadas dos
ativos do plano, juntamente com ganhos ou perdas realizados e não realizados sobre os ativos
do plano, menos:
(a) quaisquer custos de administração dos ativos do plano; e
(b) qualquer imposto devido pelo plano, exceto impostos incluídos nas premissas atuariais
utilizadas para mensurar o valor presente da obrigação de benefício definido.
Liquidação (settlement) é uma transação que elimina todas as obrigações futuras, legais ou
construtivas, em relação à totalidade ou parte dos benefícios oferecidos por plano de benefício
definido, exceto o pagamento de benefícios a empregados ou em seu nome que seja definido
nos termos do plano e incluso nas premissas atuariais.
Benefícios de curto prazo aos empregados
9.
Benefícios de curto prazo aos empregados incluem itens como, por exemplo, os seguintes,
desde que se espere que sejam integralmente liquidados em até doze meses após o período a
que se referem as demonstrações contábeis em que os empregados prestarem os respectivos
serviços:
(a) ordenados, salários e contribuições para a previdência social;
CPC_33(R1)_Rev_21
(b) licença anual remunerada e licença médica remunerada;
(c) participação nos lucros e bônus; e
(d) benefícios não monetários (tais como assistência médica, moradia, carros e bens ou
serviços gratuitos ou subsidiados) para os atuais empregados.
10. A entidade não precisa reclassificar os benefícios de curto prazo aos empregados se as
expectativas da entidade quanto à época da liquidação se modificarem temporariamente.
Contudo, se as características do benefício se modificam (como, por exemplo, a mudança de
benefício não cumulativo para benefício cumulativo) ou se a mudança nas expectativas
quanto à época da liquidação não é temporária, a entidade deve considerar então se o
benefício ainda atende à definição de benefício de curto prazo a empregados.
Reconhecimento e mensuração
Todos os benefícios de curto prazo aos empregados
11. Quando o empregado tiver prestado serviços à entidade durante o período contábil, a entidade
deve reconhecer o montante não descontado dos benefícios de curto prazo aos empregados,
que se espera sejam pagos, em troca desse serviço:
(a) como passivo (despesa acumulada), após a dedução de qualquer quantia já paga. Se a
quantia já paga exceder o valor não descontado dos benefícios, a entidade deve
reconhecer o excesso como ativo (despesa paga antecipadamente), desde que a despesa
antecipada conduza, por exemplo, a uma redução dos pagamentos futuros ou a uma
restituição de caixa;
(b) como despesa, salvo se outro Pronunciamento Técnico exigir ou permitir a inclusão dos
benefícios no custo de ativo (ver, por exemplo, os Pronunciamentos Técnicos CPC 16 –
Estoques e CPC 27 – Ativo Imobilizado).
12. Os itens 13, 16 e 19 explicam como a entidade deve aplicar o item 11 a benefícios de curto
prazo aos empregados, na forma de ausências remuneradas e planos de participação nos
lucros e bônus.
Licenças remuneradas de curto prazo
13. A entidade deve reconhecer o custo esperado de benefícios de curto prazo aos empregados na
forma de licenças remuneradas, seguindo o item 11, da seguinte forma:
(a) no caso de licenças remuneradas cumulativas, quando o serviço prestado pelos
empregados aumentar o seu direito a ausências remuneradas futuras;
(b) no caso de licenças remuneradas não cumulativas, quando as ausências ocorrerem.
14. A entidade pode remunerar os empregados por ausência por várias razões, incluindo: feriados,
doença e invalidez por curto prazo, maternidade ou paternidade, serviços de tribunais e
serviço militar. O direito a licenças remuneradas pode ser classificado em duas categorias:
(a) cumulativa; e
(b) não cumulativa.
CPC_33(R1)_Rev_21
15. Licenças remuneradas cumulativas são aquelas que podem ser estendidas e utilizadas
futuramente, se o direito adquirido no período corrente não foi totalmente utilizado. As
licenças remuneradas cumulativas podem ser com direito adquirido (vested, ou seja, os
empregados têm direito ao pagamento em dinheiro pelas licenças não gozadas no momento
em que se desligam da entidade) ou sem direito adquirido (quando os empregados não têm
direito ao pagamento em dinheiro pelas licenças não gozadas ao deixarem a entidade). Surge a
obrigação à medida que os empregados prestam serviços que aumentem o seu direito às
licenças remuneradas futuras. A obrigação existe e deve ser reconhecida, mesmo se as
ausências remuneradas forem sem direito adquirido, embora a faculdade de os empregados
poderem sair antes de utilizar o direito acumulado sem direito adquirido afete a mensuração
dessa obrigação.
16. A entidade deve mensurar o custo esperado de licenças remuneradas cumulativas como a
quantia adicional que a entidade espera pagar, em consequência do direito não utilizado que
se acumulou na data a que se referem as demonstrações contábeis.
17. O método especificado no item anterior mensura a obrigação pelo montante dos pagamentos
adicionais que se espera que ocorrerão exclusivamente pelo acúmulo de benefício. Em muitos
casos, a entidade pode não precisar fazer cálculos detalhados para estimar que não exista
obrigação relevante referente a licenças remuneradas não utilizadas. Por exemplo, uma
obrigação de
licença médica provavelmente será relevante apenas se houver um
entendimento, formal ou informal, de que a licença médica remunerada não utilizada pode ser
considerada como férias remuneradas.
Exemplo ilustrativo dos itens 16 e 17
A entidade tem 100 empregados, sendo que cada um deles tem direito a cinco dias de
trabalho de licença médica remunerada em cada ano. A licença médica não utilizada pode
ser estendida por um ano-calendário. A licença médica é excluída, em primeiro lugar, do
direito do ano corrente e, em seguida, do saldo do ano anterior (base UEPS). Em 31 de
dezembro de 20X1, o direito médio não utilizado é de dois dias por empregado. A entidade
espera, baseada na experiência passada, que essa expectativa continue, e que 92 empregados
não tirarão mais de cinco dias de licença médica remunerada em 20X2, e que os oito
empregados restantes tirarão a média de seis dias e meio cada um.
A entidade espera pagar um adicional de 12 dias de auxílio-doença em consequência do
direito não utilizado que tenha acumulado em 31 de dezembro de 20X1 (um dia e meio
cada, para oito empregados). Portanto, a entidade reconhece um passivo igual a 12 dias de
auxílio-doença.
18. As licenças remuneradas não cumulativas não são estendidas para o próximo exercício: elas
expiram se o direito não for totalmente usufruído no período corrente, e não dão aos
empregados o direito ao pagamento em dinheiro por direitos não usufruídos no momento em
que se desliguem da entidade. Esse é comumente o caso das licenças remuneradas por doença
(na medida em que o direito passado não usufruído não aumenta o direito futuro), licença
maternidade ou paternidade ou licença remunerada por serviço nos tribunais ou serviço
militar. A entidade não reconhece passivo nem despesa até a ocasião da ausência, porque o
serviço do empregado não aumenta o valor do benefício.
Planos de participação nos lucros e bônus
CPC_33(R1)_Rev_21
19. A entidade deve reconhecer o custo esperado de pagamento de participação nos lucros e
bônus de acordo com o item 11, quando e somente quando:
(a) a entidade tiver a obrigação legal ou construtiva de fazer tais pagamentos em
consequência de eventos passados; e
(b) a obrigação puder ser estimada de maneira confiável. Existe uma obrigação presente
quando e somente quando, a entidade não tem alternativa realista, a não ser efetuar os
pagamentos.
20. Em alguns planos de participação nos lucros, os empregados recebem uma parcela do lucro
somente se permanecerem na entidade durante determinado período. Tais planos criam uma
obrigação construtiva à medida que os empregados prestam serviço que aumenta a quantia a
ser paga, se permanecerem na entidade até o final do período especificado. A mensuração de
tais obrigações construtivas deve refletir a possibilidade de alguns empregados se desligarem
e não receberem a participação no lucro.
Exemplo ilustrativo do item 20
Um plano de participação nos lucros requer que a entidade pague uma parcela específica do
lucro líquido do ano aos empregados que trabalharam todo o ano. Se nenhum dos
empregados se desligar durante o ano, o total dos pagamentos de participação nos lucros
será de 3% do lucro líquido. A entidade estima que a taxa de rotatividade de pessoal reduza
os pagamentos para 2,5% do lucro líquido.
A entidade deve reconhecer um passivo e uma despesa de 2,5% do lucro líquido.
21. A entidade pode não ter obrigação legal de pagar bônus. Entretanto, em alguns casos, a
entidade adota essa prática. Em tais casos, a entidade tem uma obrigação construtiva porque a
entidade não tem alternativa realista a não ser pagar a gratificação. A mensuração da
obrigação construtiva deve refletir a possibilidade de que alguns empregados possam se
desligar sem o direito de receber a gratificação.
22. A entidade pode fazer uma estimativa confiável da sua obrigação legal ou construtiva em
conformidade com o plano de participação nos lucros ou bônus, quando e somente quando:
(a) os termos formais do plano contemplarem uma fórmula para determinar o valor do
benefício;
(b) a entidade determinar os montantes a serem pagos antes da aprovação de emissão das
demonstrações contábeis; ou
(c) a prática passada fornecer evidências claras do montante da obrigação construtiva da
entidade.
23. Uma obrigação, em conformidade com planos de participação nos lucros e bônus, resulta do
serviço prestado pelo empregado e não de transação com os sócios da entidade. Portanto, a
entidade deve reconhecer o custo dos planos de participação nos lucros e bônus não como
distribuição de lucro, mas como despesa.
24. Se as obrigações de pagamento de participação nos lucros e de bônus não forem totalmente
liquidadas dentro de doze meses após o final do período em que os empregados prestaram o
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respectivo serviço, esses pagamentos deverão ser considerados benefícios de longo prazo a
empregados (vide itens 153 a 158).
Divulgação
25. Embora este Pronunciamento não exija divulgações específicas acerca de benefícios de curto
prazo a empregados, outros Pronunciamentos podem exigi-las. Por exemplo, o
Pronunciamento Técnico CPC 05 - Divulgação sobre Partes Relacionadas exige divulgação
acerca de benefícios concedidos aos administradores da entidade. O Pronunciamento Técnico
CPC 26 - Apresentação das Demonstrações Contábeis exige a divulgação de despesas com
benefícios a empregados.
Benefícios pós-emprego: distinção entre planos de contribuição definida e planos
de benefício definido
26. Benefícios pós-emprego incluem itens como, por exemplo, os seguintes:
(a) benefícios de aposentadoria (por exemplo, pensões e pagamentos únicos por ocasião da
aposentadoria); e
(b) outros benefícios pós-emprego, tais como seguro de vida e assistência médica pós-
emprego.
Os acordos pelos quais a entidade proporciona benefícios pós-emprego são denominados
planos de benefícios pós-emprego. A entidade deve aplicar este Pronunciamento a todos os
acordos, que envolvam, ou não, o estabelecimento de entidade separada aberta ou fechada de
previdência para receber as contribuições e pagar os benefícios.
27. Os planos de benefício pós-emprego classificam-se como planos de contribuição definida ou
de benefício definido, dependendo da essência econômica do plano decorrente de seus
principais termos e condições.
28. Nos planos de contribuição definida, a obrigação legal ou construtiva da entidade está
limitada à quantia que ela aceita contribuir para o fundo. Assim, o valor do benefício pós-
emprego recebido pelo empregado deve ser determinado pelo montante de contribuições
pagas pela entidade patrocinadora (e, em alguns casos, também pelo empregado) para um
plano de benefícios pós-emprego ou para uma entidade à parte, juntamente com o retorno dos
investimentos provenientes das contribuições. Em consequência, o risco atuarial (risco de que
os benefícios sejam inferiores ao esperado) e o risco de investimento (risco de que os ativos
investidos venham a ser insuficientes para cobrir os benefícios esperados) recaem sobre o
empregado.
29. Exemplos de casos em que a obrigação da entidade não está limitada a quantia que ela
concorda em contribuir para o fundo de pensão são aqueles quando a entidade tem obrigação
legal ou construtiva por meio de:
(a) fórmula de benefício de plano que não esteja exclusivamente vinculada ao valor das
contribuições e exija que a entidade forneça contribuições adicionais se os ativos forem
insuficientes para cobrir os benefícios da fórmula de benefício de plano;
(b) garantia de retorno especificado sobre contribuições, seja direta ou indiretamente
vinculada ao plano; ou
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(c) práticas informais que dão origem a uma obrigação construtiva. Por exemplo, uma
obrigação construtiva pode surgir quando a entidade tiver histórico de aumento de
benefícios para ex-empregados para compensar a inflação, mesmo quando não houver a
obrigação legal de fazê-lo.
30. Em conformidade com os planos de benefício definido:
(a) a obrigação da entidade patrocinadora é a de fornecer os benefícios pactuados aos atuais e
aos ex-empregados; e
(b) risco atuarial (de que os benefícios venham a custar mais do que o esperado) e risco de
investimento recaem, substancialmente, sobre a entidade. Se a experiência atuarial ou de
investimento for pior que a esperada, a obrigação da entidade pode ser aumentada.
31. Os itens 32 a 49 explicam a distinção entre planos de contribuição definida e benefício
definido, no contexto de planos multiempregadores, planos de benefício definido que
compartilham riscos entre entidades sob controle comum, planos de previdência social e
benefícios segurados.
Planos multiempregadores
32. A entidade deve classificar um plano multiempregador como plano de contribuição definida
ou plano de benefício definido, de acordo com os termos do plano (incluindo qualquer
obrigação construtiva que vá além dos termos formais).
33. Se a entidade participar de plano multiempregador de benefício definido, a menos que o item
34 seja aplicável, a entidade deve:
(a) contabilizar proporcionalmente sua parcela da obrigação de benefício definido, dos ativos
do plano e do custo associado ao plano, da mesma forma como qualquer outro plano de
benefício definido; e
(b) divulgar as informações exigidas pelos itens 135 a 148 (excluindo-se o item 148(d)).
34. Quando não houver informação suficiente disponível para se adotar a contabilização de
benefício definido para plano multiempregador de benefício definido, a entidade deve:
(a) contabilizar o plano de acordo com os itens 51 e 52 como se fosse um plano de
contribuição definida;
(b) divulgar as informações exigidas pelo item 148.
35. Um exemplo de plano multiempregador de benefício definido é aquele em que:
(a) o plano é financiado em regime de repartição simples (pay-as-you-go), tal que: as
contribuições são definidas em nível que se espera ser suficiente para pagar os benefícios
que vençam no mesmo período; e os benefícios futuros adquiridos durante o período
corrente serão pagos com contribuições futuras; e
(b) os benefícios dos empregados são determinados pelo tempo de serviço e as entidades
participantes não podem se retirar do plano sem pagar uma contribuição pelos benefícios
adquiridos pelos empregados até a data de sua retirada. Esse plano representa riscos
atuariais para a entidade: se o custo final dos benefícios já adquiridos na data a que se
referem as demonstrações contábeis for maior do que o esperado, a entidade terá de
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aumentar as suas contribuições ou de persuadir os empregados a aceitar uma redução nos
benefícios. Portanto, tal plano é um plano de benefício definido.
36. Quando houver informações suficientes disponíveis sobre um plano multiempregador de
benefício definido, a entidade deve contabilizar proporcionalmente sua parcela da obrigação
de benefício definido, dos ativos do plano e do custo pós-emprego associados ao plano, da
mesma forma que para qualquer outro plano de benefício definido. Entretanto, a entidade
pode não ser capaz de identificar sua parte na posição financeira subjacente e o desempenho
do plano com confiabilidade suficiente para fins contábeis. Isso pode ocorrer, se:
(a) o plano expuser as entidades participantes a riscos atuariais associados a empregados,
atuais e antigos de outras entidades, resultando na falta de base consistente e confiável
para alocar a obrigação, os ativos do plano e o custo individualmente às entidades que
participam do plano;
(b) a entidade não tiver acesso às informações pertinentes ao plano que satisfaçam aos
requisitos deste Pronunciamento.
Nesses casos, a entidade deve contabilizar o plano como se fosse plano de contribuição
definida e divulgar as informações exigidas pelo item 148.
37. Pode haver acordo contratual, entre o plano multiempregador e seus participantes, que
determine como o excedente do plano será distribuído aos participantes (ou o déficit
custeado). A entidade patrocinadora participante no plano multiempregador, com acordo
desse tipo e que contabilize o plano como plano de contribuição definida, de acordo com o
item 34, deve reconhecer o ativo ou passivo resultante do acordo contratual e a receita ou
despesa no resultado.
Exemplo ilustrativo do item 37
A entidade participa de plano multiempregador de benefícios definidos e não prepara
avaliações do plano com base neste Pronunciamento. Portanto, contabiliza o plano como se
fosse um plano de contribuição definida. A avaliação da posição não baseada neste
Pronunciamento mostra déficit de $ 100 milhões no plano. O plano fez um acordo
contratual sobre um cronograma de contribuições com os empregadores participantes do
plano que irá eliminar o déficit nos próximos cinco anos. As contribuições totais da
entidade, de acordo com o contrato, são de $ 8 milhões.
A entidade deve reconhecer o passivo pelas contribuições ajustadas pelo valor do dinheiro
no tempo e a despesa no resultado.
38. Planos multiempregadores são distintos dos planos administrados em grupo. O plano
administrado em grupo é meramente a agregação de planos patrocinados individualmente
combinados para permitir que os empregadores reúnam os seus ativos para fins de
investimento, de maneira a reduzir os custos de gestão e de administração, mas as pretensões
dos diferentes empregadores são segregadas para o benefício exclusivo dos seus próprios
empregados. Os planos administrados em grupo não apresentam problemas contábeis
específicos porque a informação está prontamente disponível, sendo tratados da mesma forma
que qualquer outro plano patrocinado individualmente e porque tais planos não expõem as
entidades participantes a riscos atuariais, associados aos empregados atuais e antigos de outras
entidades. As definições deste Pronunciamento exigem que a entidade classifique um plano
administrado em grupo como plano de contribuição definida ou como plano de benefício
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definido de acordo com os termos do plano (incluindo qualquer obrigação construtiva, que vá
além dos termos formais).
39. Para determinar quando reconhecer e como mensurar um passivo relativo ao encerramento de
plano multiempregador de benefício definido ou à saída da entidade de plano de benefício
definido, a entidade deve aplicar o Pronunciamento CPC 25 – Provisões, Passivos
Contingentes e Ativos Contingentes.
Planos de benefício definido que compartilham riscos entre várias entidades sob controle
comum
40. Planos de benefício definido que compartilham riscos entre entidades sob controle comum,
por exemplo, uma controladora e suas subsidiárias, não são planos multiempregadores.
41. A entidade que patrocinar planos desse tipo deve obter informações acerca do plano como um
todo, mensurado de acordo com este Pronunciamento, utilizando premissas que se apliquem
ao plano como um todo. Se houver acordo contratual ou política expressa para atribuir a
despesa líquida dos benefícios definidos do plano, mensurado de acordo com este
Pronunciamento às entidades do grupo econômico, então a entidade deve, nas suas
demonstrações separadas ou individuais, reconhecer a despesa líquida correspondente aos
benefícios definidos para ela. Se não houver tal acordo ou política, a despesa líquida do
benefício definido deve ser reconhecida nas demonstrações separadas ou individuais da
entidade que é legalmente a patrocinadora do plano. As outras entidades pertencentes ao
grupo devem reconhecer, em suas demonstrações separadas ou individuais, uma despesa igual
às contribuições devidas no período.
42. A participação nesse plano é uma transação com partes relacionadas, individualmente para
cada entidade do grupo. A entidade deve, portanto, em suas demonstrações separadas ou
individuais, divulgar as informações exigidas pelo item 149.
Planos de previdência social (planos públicos)
43. A entidade deve contabilizar sua participação em plano de previdência social (planos
públicos) da mesma maneira que contabiliza sua participação em plano multiempregador
(vide itens 32 a 39).
44. Planos de previdência social são estabelecidos pela legislação e disponíveis a todas as
entidades (ou a todas as entidades de uma categoria em particular, por exemplo, um setor
específico) e são operados pelo governo ou por outro órgão (por exemplo, agência autônoma
criada especificamente para tal fim), portanto, fora do controle ou da influência da entidade
que reporta. Alguns planos estabelecidos por entidade podem, conforme a legislação, vir a
oferecer não só benefícios obrigatórios, que podem vir a substituir os benefícios que, de outra
forma, seriam cobertos por plano governamental de previdência social, bem como benefícios
voluntários adicionais. Esses planos não são planos governamentais de previdência social.
45. Planos de previdência social devem ser classificados como planos de benefício definido ou de
contribuição definida dependendo da obrigação da entidade em relação ao plano. Muitos
planos governamentais de previdência social, como o brasileiro, são custeados em regime de
repartição simples (pay-as-you-go): as contribuições são fixadas em um nível que se espera
sejam suficientes para cobrir os benefícios concedidos que vençam no mesmo período;
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benefícios futuros obtidos durante o período corrente serão pagos com contribuições futuras.
Contudo, na maioria dos planos de previdência social, a entidade não tem obrigação legal ou
construtiva de pagar esses benefícios futuros, sendo que a sua única obrigação é a de pagar as
contribuições à medida que se vencem e, se a entidade deixar de empregar membros do plano
da previdência social, ela não terá a obrigação de pagar os benefícios auferidos por seus
empregados em anos anteriores. Por essa razão, os planos de previdência social são
normalmente planos de contribuição definida. Entretanto, quando um plano de previdência
social vier a ser classificado como plano de benefício definido, a entidade deve aplicar o
tratamento previsto nos itens 32 a 39.
Seguro de benefícios
46. A entidade pode pagar prêmios de seguro para custear um plano de benefícios pós-emprego.
A entidade deve tratar o plano como plano de contribuição definida, exceto se a entidade tiver
(direta ou indiretamente por meio do plano) a obrigação legal ou construtiva de:
(a) pagar os benefícios dos empregados diretamente quando se vencerem; ou
(b) pagar contribuições adicionais se a seguradora não cobrir todos os benefícios futuros do
empregado relativos aos serviços prestados no período corrente e em períodos anteriores.
Se a entidade tiver a obrigação legal ou construtiva, o plano deve ser tratado como plano de
benefício definido.
47. Os benefícios segurados por apólice de seguro não precisam ter relação direta ou automática
com a obrigação da entidade em relação aos benefícios a empregados. Os planos de benefícios
pós-emprego que envolvam apólices de seguro estão sujeitos à mesma distinção entre
contabilização e financiamento aplicável a outros planos custeados.
48. Quando a entidade custeia uma obrigação de benefícios pós-emprego ao contribuir para uma
apólice de seguro pela qual a entidade (direta ou indiretamente por meio do plano, utilizando-
se de mecanismo de fixação de prêmios futuros ou por meio de relacionamento com a
seguradora) mantém a obrigação legal ou construtiva, o pagamento dos prêmios não
corresponde a um acordo de contribuição definida. Como consequência a entidade:
(a) deve contabilizar a apólice de seguro elegível como ativo de plano (vide item 8); e
(b) deve reconhecer outras apólices de seguro como direitos de reembolso (se as apólices
satisfizerem aos critérios do item 116).
49. Quando a apólice de seguro estiver no nome de participante específico do plano ou de grupo
de participantes e a entidade não tiver nenhuma obrigação legal ou construtiva de cobrir
qualquer perda na apólice, a entidade não tem obrigação de pagar benefícios aos empregados,
e a seguradora tem a responsabilidade exclusiva de pagar esses benefícios. O pagamento de
prêmios fixos, segundo tais contratos, é, na verdade, a liquidação da obrigação de benefícios
ao empregado e, não, um investimento para cobrir a obrigação. Consequentemente, a entidade
deixa de possuir um ativo ou um passivo. Portanto, a entidade trata tais pagamentos como
contribuições para plano de contribuição definida.
Benefícios pós-emprego: plano de contribuição definida
50. A contabilização dos planos de contribuição definida é direta porque a obrigação da entidade
patrocinadora relativa a cada exercício é determinada pelos montantes a serem contribuídos
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no período. Consequentemente, não são necessárias premissas atuariais para mensurar a
obrigação ou a despesa, e não há possibilidade de qualquer ganho ou perda atuarial. Além
disso, as obrigações são mensuradas em base não descontada, exceto quando não são
completamente liquidados em até doze meses após o final do período em que os empregados
prestam o respectivo serviço.
Reconhecimento e mensuração
51. Quando o empregado tiver prestado serviços à entidade durante um período, a entidade deve
reconhecer a contribuição devida para plano de contribuição definida em troca desses
serviços:
(a) como passivo (despesa acumulada), após a dedução de qualquer contribuição já paga. Se
a contribuição já paga exceder a contribuição devida relativa ao serviço prestado antes do
período contábil a que se referem as demonstrações contábeis, a entidade deve reconhecer
esse excesso como ativo (despesa antecipada), na medida em que as antecipações
conduzirão, por exemplo, a uma redução nos pagamentos futuros ou em um reembolso
em dinheiro; e
(b) como despesa, a menos que outro Pronunciamento exija ou permita a inclusão da
contribuição no custo de ativo (ver, por exemplo, os Pronunciamentos Técnicos CPC 16 -
Estoques e CPC 27 – Ativo Imobilizado).
52. Quando as contribuições para plano de contribuição definida não são completamente
liquidados em até doze meses após o final do período da prestação de serviço pelo
empregado, elas devem ser descontadas, utilizando-se a taxa de desconto especificada no item
83.
Divulgação
53. A entidade deve divulgar o montante reconhecido como despesa para os planos de
contribuição definida.
54. Sempre que exigido pelo Pronunciamento Técnico CPC 05 – Divulgação sobre Partes
Relacionadas, a entidade divulga informação acerca das contribuições para planos de
contribuição definida relativas aos administradores da entidade.
Benefícios pós-emprego: plano de beneficio definido
55. A contabilização dos planos de benefício definido é complexa porque são necessárias
premissas atuariais para mensurar a obrigação e a despesa do plano, bem como existe a
possibilidade de ganhos e perdas atuariais. Além disso, as obrigações são mensuradas ao seu
valor presente, porque podem ser liquidadas muitos anos após a prestação dos serviços pelos
empregados.
Reconhecimento e mensuração
56. Planos de benefício definido podem não ter fundo constituído ou podem ser total ou
parcialmente cobertos por contribuições da entidade e, algumas vezes, dos seus empregados,
para a entidade ou fundo legalmente separado da entidade patrocinadora, e a partir do qual são
pagos os benefícios a empregados. O pagamento dos benefícios concedidos depende não
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somente da situação financeira e do desempenho dos investimentos do fundo, mas também da
capacidade e do interesse da entidade de suprir qualquer insuficiência nos ativos do fundo.
Portanto, a entidade assume, na essência, os riscos atuariais e de investimento associados ao
plano. Consequentemente, a despesa reconhecida de plano de benefício definido não é
necessariamente o montante da contribuição devida relativa ao período.
57. A contabilização de planos de benefício definido pela entidade envolve os seguintes passos:
(a) determinar o déficit ou superávit. Isto envolve:
(i) utilizar uma técnica atuarial, o método de crédito unitário projetado, para estimar de
maneira confiável o custo final para a entidade do benefício obtido pelos empregados
em troca dos serviços prestados nos períodos corrente e anteriores (vide itens 67 a
69). Isso exige que a entidade determine quanto do benefício deve ser atribuível aos
períodos corrente e anteriores (vide itens 70 a 74) e que faça estimativas (premissas
atuariais) acerca de variáveis demográficas (tais como rotatividade e mortalidade de
empregados) e variáveis financeiras (tais como futuros aumentos nos salários e nos
custos médicos), que afetarão o custo do benefício (vide itens 75 a 98);
(ii) descontar esse benefício para determinar o valor presente da obrigação de benefício
definido e o custo do serviço corrente (vide itens 67 a 69 e 83 a 86);
(iii) deduzir o valor justo de quaisquer ativos do plano (vide itens 113 a 115) do valor
presente da obrigação de benefício definido;
(b) determinar o valor líquido de passivo (ativo) de benefício definido como o valor do
déficit ou superávit determinado em (a), ajustado por qualquer efeito de limitação de
ativo líquido de benefício definido ao teto de ativo (asset ceiling) (vide item 64);
(c) determinar os valores a serem reconhecidos em resultado:
(i) custo do serviço corrente (vide itens 70 a 74);
(i) custo do serviço corrente (ver itens 70 a 74 e 122A); (Alterado pela Revisão CPC 13)
(ii) qualquer custo do serviço passado e ganho ou perda na liquidação (vide itens 99 a
112);
(iii) juros líquidos sobre o valor líquido de passivo (ativo) de benefício definido (vide
itens 123 a 126);
(d) determinar as remensurações do valor líquido de passivo (ativo) de benefício definido, a
serem reconhecidas em outros resultados abrangentes, compreendendo:
(i) ganhos e perdas atuariais (vide itens 128 e 129);
(ii) retorno sobre os ativos do plano, excluindo valores considerados nos juros líquidos
sobre o valor líquido de passivo (ativo) de benefício definido (vide item 130); e
(iii) qualquer mudança no efeito do teto de ativo (asset ceiling) (vide item 64), excluindo
os valores considerados nos juros líquidos sobre o valor líquido de passivo (ativo) de
benefício definido.
Quando a entidade possuir mais de um plano de benefício definido, deve aplicar esses
procedimentos separadamente para cada plano relevante.
58. A entidade deve determinar o valor líquido de passivo (ativo) de benefício definido com
suficiente regularidade de modo que os montantes reconhecidos nas demonstrações contábeis
não divirjam significativamente dos valores que seriam determinados no final do período.
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59. Este Pronunciamento encoraja, mas não requer que a entidade envolva atuário habilitado na
mensuração de todas as obrigações relevantes de benefícios pós-emprego. Por razões práticas,
a entidade pode solicitar a um atuário habilitado que realize uma avaliação detalhada da
obrigação antes do final do período contábil a que se referem as demonstrações contábeis.
Contudo, os resultados dessa avaliação devem ser atualizados com base em transações
relevantes e em outras mudanças significativas nas circunstâncias (incluindo alterações nos
valores de mercado e nas taxas de juro) até o final do período contábil a que se referem as
demonstrações contábeis.
60. Em alguns casos, as estimativas, as médias e as simplificações de cálculo podem proporcionar
uma aproximação confiável dos cálculos detalhados ilustrados neste Pronunciamento.
Contabilização da obrigação construtiva
61. A entidade deve contabilizar não somente a sua obrigação legal segundo os termos formais de
plano de benefício definido, mas também qualquer obrigação construtiva que surja a partir das
práticas informais da entidade. As práticas informais dão origem a uma obrigação construtiva
quando a entidade não tiver alternativa realista a não ser pagar os benefícios aos empregados.
Um exemplo de obrigação construtiva é quando uma alteração nas práticas informais da
entidade causaria um dano inaceitável no seu relacionamento com os empregados.
62. Os termos formais de plano de benefício definido podem permitir que a entidade encerre sua
obrigação com o plano. Não obstante, é normalmente difícil para a entidade encerrar sua
obrigação com o plano (sem pagamento) se os empregados tiverem de ser mantidos. Portanto,
na ausência de evidência em sentido contrário, a contabilização de benefícios pós-emprego
pressupões que a entidade que prometa esses benefícios continuará a fazê-lo durante o tempo
de trabalho remanescente dos empregados.
Balanço patrimonial
63. A entidade deve reconhecer o valor líquido de passivo (ativo) de benefício definido na
demonstração contábil.
64. Quando a entidade obtiver um superávit no plano de benefício definido, ela deve mensurar o
valor líquido de ativo de benefício definido como sendo o menor dentre:
(a) o superávit no plano de benefício definido; e
(b) o teto de ativo (asset ceiling), determinado pela aplicação da taxa de desconto
especificada no item 83.
65. O valor líquido de ativo de benefício definido pode surgir quando um plano de benefício
definido tiver recebido excesso de contribuições ou quando ocorrerem ganhos atuariais. A
entidade deve reconhecer o valor líquido de ativo de benefício definido nesses casos porque:
(a) a entidade controla um recurso, que é a capacidade de utilizar o superávit para gerar
benefícios futuros;
(b) esse controle é resultado de eventos passados (contribuições pagas pela entidade e
serviços prestados pelo empregado); e
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(c) benefícios econômicos futuros estão disponíveis para a entidade na forma de redução nas
contribuições futuras ou de restituição em dinheiro, seja diretamente à entidade
patrocinadora ou indiretamente para outro plano deficitário. O teto de ativo (asset ceiling)
é o valor presente desses benefícios futuros.
Reconhecimento e mensuração: valor presente de obrigação por benefício definido e custo do
serviço corrente
66. O custo final de plano de benefício definido pode ser influenciado por muitas variáveis, tais
como salários na data da concessão do benefício, rotatividade e mortalidade, contribuições de
empregados e tendências de custos médicos. O custo final do plano é incerto e é provável que
essa incerteza venha a permanecer por longo período de tempo. Com o objetivo de mensurar o
valor presente das obrigações de benefício pós-emprego e o respectivo custo do serviço
corrente, é necessário:
(a) aplicar método de avaliação atuarial (vide itens 67 a 69);
(b) atribuir benefício aos períodos de serviço (vide itens 70 a 74); e
(c) adotar premissas atuariais (vide itens 75 a 98).
Método de avaliação atuarial
67. A entidade deve utilizar o Método de Crédito Unitário Projetado para determinar o valor
presente das obrigações de benefício definido e o respectivo custo do serviço corrente e,
quando aplicável, o custo do serviço passado.
68. O Método de Crédito Unitário Projetado (também conhecido como método de benefícios
acumulados com pro rata de serviço ou como método benefício/anos de serviço) considera
cada período de serviço como dando origem a uma unidade adicional de direito ao benefício
(vide itens 70 a 74) e mensura cada unidade separadamente para construir a obrigação final
(vide itens 75 a 98).
Exemplo ilustrativo do item 68
Um benefício de pagamento único a ser liquidado ao final do período trabalhado
corresponde a 1% do salário final para cada ano de serviço. O salário no ano 1 é $ 10.000 e
assume-se um crescimento anual de 7% (composto) para cada ano. A taxa de desconto
utilizada é de 10% ao ano. A tabela a seguir demonstra como a obrigação é calculada para
um empregado cuja expectativa de desligamento é ao final do ano 5, assumindo que não
haverá mudanças nas premissas atuariais. Para fins de simplificação, este exemplo não
considera o ajuste adicional necessário para refletir a probabilidade de o empregado deixar a
entidade em data anterior ou posterior.
Ano
1
2
3
4
5
Benefício atribuído a:
– anos anteriores
– ano corrente (1% do salário final)
$ 0
$ 131
$ 131 $ 262 $ 393 $ 524
$ 131 $ 131 $ 131 $ 131
– ano corrente e anteriores
$ 131
$ 262 $ 393 $ 524 $ 655
CPC_33(R1)_Rev_21
Obrigação
Inicial
Jurosde10%
-
-
$ 89
$ 196 $ 324 $ 476
$ 9
$ 20
$ 33
$ 48
Custo do serviço corrente
$ 89 $ 98
$ 108 $ 119 $ 131
Obrigação final
$ 89 $ 196 $ 324 $ 476 $ 655
Notas:
1. A obrigação inicial é o valor presente do benefício atribuído a anos anteriores.
2. O custo do serviço corrente é o valor presente do benefício atribuído ao ano corrente.
A obrigação final é o valor presente do benefício atribuído aos anos corrente e anteriores.
69. A entidade deve descontar a valor presente o total da obrigação de benefícios pós-emprego,
mesmo se parte da obrigação vencer em até doze meses após a data das demonstrações
contábeis.
Atribuição de benefício a períodos de serviço
70. Na determinação do valor presente das obrigações de benefício definido e do respectivo custo
do serviço corrente e, quando aplicável, do custo do serviço passado, a entidade deve atribuir
benefício a períodos de serviço de acordo com a fórmula de benefício do plano. Entretanto, se
o serviço do empregado nos últimos anos conduzir a um benefício significativamente mais
elevado do que em períodos anteriores, a entidade deve atribuir benefícios em bases lineares,
desde:
(a) a data em que o serviço do empregado conduz, pela primeira vez, a benefícios previstos
no plano (quer os benefícios estejam, ou não, condicionados ao serviço futuro); até
(b) a data em que o serviço futuro do empregado não levar a uma quantia relevante de
benefícios adicionais conforme o plano, exceto nos casos provenientes de novos
aumentos de salário.
71. O Método de Crédito Unitário Projetado exige que a entidade atribua benefício ao período
corrente (a fim de determinar o custo do serviço corrente) e aos períodos corrente e anteriores
(a fim de determinar o valor presente das obrigações de benefício definido). A entidade deve
atribuir benefício aos períodos em que surge a obrigação de proporcionar benefícios pós-
emprego. Essa obrigação surge à medida que os empregados prestam serviços em troca de
benefícios pós-emprego e que a entidade espera pagar em períodos futuros. As técnicas
atuariais permitem que a entidade mensure essa obrigação com confiabilidade suficiente para
justificar o reconhecimento do passivo.
Exemplos ilustrativos do item 71
1 Um plano de benefício definido proporciona o benefício de pagamento único de $ 100
devido por ocasião da aposentadoria, para cada ano de serviço prestado.
Atribui-se a cada ano o benefício de $ 100. O custo do serviço corrente é o valor
presente de $ 100. O valor presente da obrigação de benefício definido é o valor
presente de $ 100, multiplicado pelo número de anos de serviço na data a que se
referem as demonstrações contábeis.
CPC_33(R1)_Rev_21
Se o benefício for devido imediatamente quando o empregado se desliga da entidade, o
custo do serviço corrente e o valor presente da obrigação de benefício definido
refletem a data em que se espera que o empregado se desligue.
Assim, devido ao efeito do desconto a valor presente, eles são inferiores às quantias
que seriam determinadas se o empregado saísse no final do período a que se referem
as demonstrações contábeis.
2 Um plano proporciona uma pensão mensal de 0,2% do salário final para cada ano de
serviço. A pensão é devida a partir da idade de 65 anos.
É atribuído a cada ano de serviço um benefício igual ao valor presente, à data
esperada de aposentadoria da pensão mensal de 0,2% do salário final estimado,
devido a partir da data esperada de aposentadoria até a data estimada do falecimento.
O custo do serviço corrente é o valor presente desse benefício. O valor presente da
obrigação de benefício definido é o valor presente dos pagamentos mensais de pensão
de 0,2% do salário final, multiplicado pelo número de anos de serviço até o final do
período a que se referem as demonstrações contábeis. O custo do serviço corrente e o
valor presente da obrigação de benefício definido
72. O serviço prestado pelo empregado origina uma obrigação em conformidade com o plano de
benefício definido, mesmo se os benefícios estiverem condicionados à manutenção da
condição de empregado (em outras palavras, mesmo quando os benefícios ainda não foram
adquiridos). O serviço do empregado, antes da data de aquisição de direito, dá origem a uma
obrigação construtiva porque, ao final de cada encerramento de exercício, o valor do serviço
futuro que o empregado deverá prestar até a aquisição do direito ao benefício se reduz. Ao
mensurar a obrigação de benefício definido, a entidade deve considerar a probabilidade de
que alguns empregados possam não satisfazer aos requisitos de aquisição de direito. De
maneira similar, embora determinados benefícios pós-emprego, por exemplo, benefícios
médicos pós-emprego, só se tornem devidos se ocorrer evento específico, quando o
empregado já tenha se aposentado, uma obrigação deve ser reconhecida à medida que o
empregado estiver prestando serviço que proporcionará o direito ao benefício. A
probabilidade de que o evento específico ocorrerá afeta a mensuração da obrigação, mas não
determina se a obrigação existe ou não.
Exemplos ilustrativos do item 72
1 Um plano paga o benefício de $ 100 para cada ano de serviço. A aquisição de direito
aos benefícios ocorrerá após dez anos de prestação de serviço.
O benefício de $ 100 é atribuído a cada ano. Em cada um dos primeiros dez anos, o
custo do serviço corrente e o valor presente da obrigação refletem a probabilidade de
que o empregado possa não completar dez anos de serviço.
2 Um plano paga o benefício de $ 100 para cada ano de serviço prestado, excluindo o
serviço antes da idade de 25 anos. A aquisição de direito aos benefícios ocorre
imediatamente.
Nenhum benefício deve ser atribuído ao serviço prestado antes da idade de 25 anos,
CPC_33(R1)_Rev_21
porque o serviço, antes dessa data, não leva a benefícios (condicionais ou
incondicionais). O benefício de $ 100 é atribuído a cada ano subsequente.
73. A obrigação aumenta até a data em que o posterior serviço prestado pelo empregado não mais
dê lugar a valores relevantes de benefícios futuros. Portanto, todo o benefício é atribuído aos
períodos que terminem nessa data ou antes dela. O benefício é atribuído a períodos contábeis
individuais de acordo com a fórmula de benefício do plano. Entretanto, se o serviço do
empregado em anos adicionais conduzir a um nível significativamente maior de benefício do
que nos anos anteriores, a entidade deve atribuir o benefício de maneira linear até a data em
que o serviço posterior do empregado conduza a uma quantia imaterial de benefícios
adicionais. Isso ocorre porque o serviço do empregado conduzirá, em última análise, a um
benefício em nível mais elevado.
Exemplos ilustrativos do item 73
1 Um plano paga o benefício em parcela única de $ 1.000, cuja aquisição de direito
ocorre após dez anos de serviço prestado. O plano não prevê benefício adicional para
serviço subsequente.
O benefício de $ 100 ($ 1.000 dividido por dez) é atribuído a cada um dos primeiros
dez anos.
O custo do serviço corrente, em cada um dos primeiros dez anos, reflete a
probabilidade de o empregado não completar os dez anos de serviço. Nenhum
benefício é atribuído aos anos subsequentes.
2 Um plano paga o benefício de aposentadoria em parcela única no valor de $ 2.000 a
todos os empregados que ainda estejam trabalhando na idade de 55 anos, após terem
prestado vinte anos de serviço, ou que ainda estejam empregados à idade de 65,
independentemente de seu tempo de serviço.
Para os empregados que sejam admitidos antes da idade de 35 anos, serão computados
benefícios apenas quando possuírem 35 anos de idade (o empregado pode deixar a
entidade com 30 anos e retornar ao serviço com 33 anos de idade, sem nenhum efeito
no montante ou prazo dos benefícios). Esses benefícios estão condicionados a serviço
futuro. Além disso, os serviços prestados pelos empregados após os 55 anos de idade
não trarão benefícios futuros significativos. Para esses empregados, a entidade atribui
um benefício de $ 100 ($ 2.000 dividido por 20) para cada ano, desde a idade de 35 até
55 anos.
Para os empregados admitidos com idades entre 35 e 45 anos, o serviço prestado após
20 anos não trará benefícios adicionais significativos. Para esses empregados, a
entidade atribui benefício de $ 100 ($ 2.000 dividido por 20) para cada um dos
primeiros 20 anos.
Para o empregado admitido com 55 anos de idade, o serviço prestado depois de 10
anos não conduzirá à um montante significativo de benefícios. Para este empregado, a
entidade atribui benefício de $ 200 ($ 2.000 dividido por 10) para cada um dos 10
primeiros anos.
CPC_33(R1)_Rev_21
Para todos os empregados, o custo do serviço corrente e o valor presente da obrigação
devem refletir a probabilidade de o empregado não completar o período necessário de
prestação de serviço.
3 Um plano médico pós-emprego reembolsa 40% dos custos médicos se o empregado
sair da entidade depois de ter prestado serviço entre 10 a 20 anos, ou o reembolso será
de 50% dos custos, caso o empregado deixe a entidade após 20 ou mais anos de
serviço.
De acordo com a fórmula de benefício do plano, a entidade atribui 4% do valor
presente dos custos médicos esperados (40% dividido por dez) a cada um dos
primeiros 10 anos e 1% (10% dividido por 10) a cada um dos 10 anos subsequentes. O
custo do serviço corrente em cada ano deve refletir a probabilidade de o empregado
não completar o período de serviço necessário à obtenção parcial ou integral do
benefício.
Para os empregados que a entidade espera que se desliguem dentro de 10 anos,
nenhum benefício deve ser atribuído.
4 Um plano médico pós-emprego reembolsa 10% dos custos se o empregado deixar a
entidade após ter prestado serviço entre 10 e 20 anos, ou o reembolso será de 50% dos
custos, caso o empregado deixar a entidade após 20 ou mais anos de serviço.
O serviço em anos posteriores conduzirá a um nível de benefícios significativamente
maior do que os anos atuais.
Portanto, para os empregados com expectativa de desligamento após 20 ou mais anos,
a entidade atribui benefício em base linear, conforme o item 71. O serviço prestado
após 20 anos não conduzirá a um montante significativo de benefícios futuros.
Portanto, o benefício atribuído a cada um dos primeiros 20 anos é de 2,5% do valor
presente dos custos médicos esperados (50% dividido por vinte).
Para os empregados cuja expectativa de desligamento for entre 10 e 20 anos, o
benefício atribuído a cada um dos primeiros 10 anos é de 1% do valor presente dos
custos médicos esperados. Para esses empregados, nenhum benefício é atribuído ao
serviço entre o final do décimo ano e a data estimada de saída.
Para os empregados que se espera que saiam dentro de dez anos, nenhum benefício
deve ser atribuído.
74. Quando o montante de benefício for uma proporção constante do salário final para cada ano
de serviço prestado, os futuros aumentos salariais afetarão o montante necessário para liquidar
a obrigação referente ao serviço prestado antes do período contábil a que se referem as
demonstrações contábeis, mas não cria uma obrigação adicional. Portanto:
(a) para a finalidade do item 70(b), os aumentos de salário não conduzem a benefícios
adicionais, mesmo que o valor dos benefícios dependa do salário final; e
CPC_33(R1)_Rev_21
(b) a quantia do benefício atribuído a cada período é uma proporção constante do salário ao
qual o benefício está atrelado.
Exemplo ilustrativo do item 74
Os empregados têm direito a um benefício de 3% do salário final para cada ano de serviço
prestado, antes de completar a idade de 55 anos.
O benefício de 3% do salário final estimado é atribuído a cada ano até completar a idade
de 55. Essa é a data em que o posterior serviço do empregado não conduzirá a quantia
significativa de benefícios futuros de acordo com o plano. Nenhum benefício é atribuído ao
serviço após essa idade.
Premissas atuariais
75. As premissas atuariais devem ser imparciais (não enviesadas) e devem ser mutuamente
compatíveis.
76. As premissas atuariais devem ser as melhores estimativas da entidade sobre as variáveis que
determinarão o custo final de prover benefícios pós-emprego. As premissas atuariais
compreendem:
(a) premissas demográficas acerca das características futuras dos atuais e ex-empregados (e
seus dependentes) que sejam elegíveis aos benefícios. Premissas demográficas tratam de
tópicos, tais como:
(i) mortalidade (vide itens 81 e 82);
(ii) taxas de rotatividade de empregados, invalidez e aposentadoria antecipada;
(iii) a proporção de participantes do plano com dependentes que serão elegíveis aos
benefícios;
(iv) a proporção de participantes do plano que escolherá cada opção de forma de
pagamento disponível conforme os termos do plano; e
(v) taxas de sinistralidade dos planos médicos;
(b) premissas financeiras que abordam tópicos como:
(i) taxa de desconto (vide itens 83 a 86);
(ii) níveis de benefícios, excluindo qualquer custo dos benefícios que deva correr por
conta de empregados, e salário futuro (vide itens 87 a 95);
(iii) no caso de benefícios médicos, custos médicos futuros, incluindo custos de
administração de sinistros (ou seja, os custos que serão incorridos no processamento
e solução de sinistros, incluindo honorários legais e taxas de reguladores) (vide itens
96 a 98); e
(iv) impostos devidos pelo plano sobre contribuições relativas a serviços anteriores à data
das demonstrações contábeis ou sobre benefícios decorrentes desses serviços.
77. As premissas atuariais devem ser imparciais (não enviesadas) se elas não forem imprudentes
nem excessivamente conservadoras.
CPC_33(R1)_Rev_21
78. As premissas atuariais devem ser mutuamente compatíveis se refletirem as relações
econômicas entre fatores, tais como inflação, taxas de crescimento salarial e taxa de desconto.
Por exemplo, todas as premissas que dependem de determinado nível de inflação (tais como
premissas sobre taxas de juros, aumentos de salários e de benefícios) para qualquer período
futuro deverão pressupor o mesmo nível de inflação.
79. A entidade deve determinar a taxa de desconto e outras premissas financeiras em termos
nominais (taxa de inflação inclusa), exceto se as estimativas em termos reais (líquidas da taxa
de inflação) forem mais confiáveis, por exemplo, em economia hiperinflacionária ou quando
o benefício for indexado e existir mercado estruturado de títulos de dívida indexados na
mesma moeda e prazo.
80. As premissas financeiras devem basear-se em expectativas de mercado na data a que se
referem as demonstrações contábeis, relativamente ao período ao longo do qual deverão ser
liquidadas as obrigações.
Premissas atuariais: mortalidade
81. A entidade deve determinar suas premissas de mortalidade tendo por referência à sua melhor
estimativa de mortalidade dos participantes do plano tanto durante quanto após o emprego.
82. A fim de estimar o custo final do benefício, a entidade deve considerar as mudanças esperadas
na taxa de mortalidade, por exemplo, ajustando as tábuas-padrão de mortalidade com
estimativas de melhorias na mortalidade.
Premissas atuariais: taxa de desconto
83. A taxa utilizada para descontar a valor presente as obrigações de benefícios pós-emprego
(tanto custeadas quanto não custeadas) deve ser determinada com base nos rendimentos de
mercado, apurados na data a que se referem as demonstrações contábeis, para títulos ou
obrigações corporativas de alta qualidade. Se não houver mercado ativo desses títulos, devem
ser usados os rendimentos de mercado (na data a que se referem as demonstrações contábeis)
relativos aos títulos do Tesouro Nacional. A moeda e o prazo desses instrumentos financeiros
devem ser consistentes com a moeda e o prazo estimado das obrigações de benefício pós-
emprego.
83. A taxa utilizada para descontar a valor presente as obrigações de benefícios pós-emprego
(tanto custeadas quanto não custeadas) deve ser determinada com base nos rendimentos de
mercado, apurados na data a que se referem as demonstrações contábeis, para títulos ou
obrigações corporativas de alta qualidade. Para moedas para as quais não existe mercado ativo
desses títulos corporativos de alta qualidade, devem ser usados os rendimentos de mercado
(na data a que se referem às demonstrações contábeis) relativos aos títulos do Tesouro
Nacional nessa moeda. A moeda e o prazo desses instrumentos financeiros devem ser
consistentes com a moeda e o prazo estimado das obrigações de benefício pós-emprego.
(Alterado pela Revisão CPC 08)
84. Uma premissa atuarial que tem efeito significativo é a taxa de desconto. A taxa de desconto
deve refletir o valor do dinheiro no tempo, mas não o risco atuarial ou de investimento. Além
disso, a taxa de desconto não deve refletir o risco de crédito específico da entidade suportado
CPC_33(R1)_Rev_21
pelos seus credores, nem refletir o risco de a experiência futura poder diferir das premissas
atuariais.
85. A taxa de desconto deve refletir os prazos estimados dos pagamentos de benefícios. Na
prática, a entidade frequentemente consegue isso, aplicando uma única taxa de desconto
média ponderada que reflita os prazos estimados e o montante dos pagamentos de benefícios e
a moeda em que os benefícios vão ser pagos.
86. Em alguns casos, pode não haver mercado ativo de títulos de dívida com vencimento
suficientemente longo para corresponder ao vencimento estimado de todos os pagamentos de
benefícios. Nesses casos, a entidade utiliza as taxas correntes de mercado, com o prazo
apropriado, para descontar pagamentos de prazos mais curtos e estima a taxa de desconto para
vencimentos mais longos, extrapolando as taxas correntes de mercado ao longo da curva de
rendimento. É improvável que o valor presente total de obrigação de benefício definido seja
particularmente sensível à taxa de desconto aplicada à parcela dos benefícios devidos após o
vencimento final dos títulos de dívida corporativos ou dos títulos do Tesouro Nacional
disponíveis.
Premissas atuariais: salários, benefícios e custos médicos
87. A entidade deve mensurar suas obrigações de benefício definido em base que reflita:
(a) os benefícios estabelecidos nos termos do plano (ou resultantes de qualquer obrigação
construtiva que vá além desses termos), no final do período a que se referem as
demonstrações contábeis;
(b) quaisquer aumentos salariais estimados futuros que afetem os benefícios devidos;
(c) o efeito de qualquer limite sobre a parcela do empregador no custo dos benefícios
futuros;
(d) contribuições de empregados ou de terceiros que reduzam o custo final desses benefícios
para a entidade; e
(e) as mudanças futuras estimadas no nível de benefícios de previdência social que afetem os
benefícios devidos segundo um plano de benefício definido, se, e somente se:
(i) essas mudanças tiverem sido decretadas antes do período contábil a que se referem as
demonstrações contábeis; ou
(ii) dados históricos ou outras evidências confiáveis indicarem que esses benefícios de
previdência social mudarão de alguma forma previsível, por exemplo, de acordo com
mudanças futuras nos níveis gerais de preço ou nos níveis gerais de salário.
88. As premissas atuariais devem refletir alterações em benefícios futuros que estejam
estabelecidos nos termos formais de plano (ou obrigação construtiva que vá além desses
termos) no final do período a que se referem as demonstrações contábeis. Esse é o caso
quando, por exemplo:
(a) a entidade tem um histórico de benefícios crescentes, por exemplo, para mitigar os efeitos
da inflação e não exista indício de que essa prática se alterará no futuro;
(b) a entidade está obrigada, seja pelos termos formais de plano (ou obrigação construtiva
que vá além desses termos) ou pela legislação, a usar quaisquer excedentes deste plano
para benefício dos participantes do plano (vide item 108(c)); ou
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(c) os benefícios variam em resposta a uma meta de desempenho ou outros critérios. Por
exemplo, os termos do plano podem dispor que haverá redução do valor dos benefícios
ou exigirá contribuições adicionais dos empregados se os ativos do plano forem
insuficientes. A mensuração da obrigação deve refletir a melhor estimativa do efeito da
meta de desempenho ou outros critérios.
89. As premissas atuariais não refletem alterações nos benefícios futuros que não estejam
estabelecidas nos termos formais do plano (ou de obrigação construtiva) na data a que se
referem as demonstrações contábeis. Tais alterações resultarão em:
(a) custo do serviço passado, na medida em que alterem benefícios relativos ao serviço
prestado antes da alteração; e
(b) custo do serviço corrente relativo a períodos posteriores à alteração, na medida em que
eles modifiquem os benefícios relativos a serviços posteriores à alteração.
90. As estimativas de futuros aumentos salariais devem levar em consideração a inflação, a
experiência, as promoções e outros fatores relevantes, tais como oferta e demanda no mercado
de trabalho.
91. Alguns planos de benefício definido limitam as contribuições que a entidade está obrigada a
pagar. O custo final dos benefícios considera o efeito do limite sobre as contribuições. O
efeito do limite sobre contribuições é determinado pelo que for mais curto dentre:
(a) a vida estimada da entidade; e
(b) a vida estimada do plano.
92. Alguns planos de benefício definido exigem que os empregados ou terceiros contribuam para
o custo do plano. As contribuições dos empregados reduzem o custo dos benefícios para a
entidade. A entidade considera se contribuições de terceiros reduzem o custo dos benefícios
para a entidade ou constituem um direito a reembolso, conforme descrito no item 116.
Contribuições de empregados ou de terceiros são estabelecidas nos termos formais do plano
(ou resultam de obrigação construtiva que vá além desses termos) ou são discricionárias.
Contribuições discricionárias de empregados ou de terceiros reduzem o custo do serviço por
ocasião do pagamento dessas contribuições ao plano.
93. Contribuições de empregados ou de terceiros estabelecidas nos termos formais do plano
reduzem o custo do serviço (se estiverem atreladas ao serviço) ou reduzem as remensurações
do valor líquido de passivo (ativo) de benefício definido (por exemplo, se as contribuições
forem exigidas para reduzir déficit decorrente de perdas sobre os ativos do plano ou de perdas
atuariais). Contribuições de empregados ou de terceiros relacionadas ao serviço são atribuídas
a períodos de serviço como benefício negativo, de acordo com o item 70 (ou seja, o benefício
líquido é atribuído de acordo com esse item).
93. Contribuições de empregados ou de terceiros estabelecidas nos termos formais do plano
reduzem o custo do serviço (se estiverem atreladas ao serviço) ou afetam as remensurações do
valor líquido de passivo (ativo) de benefício definido (se não estiverem atreladas ao serviço).
Um exemplo de contribuições que não estão atreladas ao serviço é quando as contribuições
forem exigidas para reduzir déficit decorrente de perdas sobre os ativos do plano ou de perdas
atuariais. Se as contribuições de empregados ou de terceiros atreladas ao serviço, essas
contribuições reduzem o custo do serviço da seguinte forma:
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(a) se o montante das contribuições depende do número de anos de serviço, a entidade deve
atribuir as contribuições para períodos de serviço, utilizando o mesmo método de
atribuição exigido pelo item 70 para o benefício bruto (isto é, utilizando a fórmula de
contribuição do plano ou a forma linear); ou
(b) se o montante das contribuições independe do número de anos de serviço, a entidade está
autorizada a reconhecer tais contribuições como redução do custo do serviço no período
em que o serviço relacionado seja prestado. Exemplos de contribuições que são
independentes do número de anos de serviço incluem aqueles que são uma percentagem
fixa do salário do empregado, um valor fixo durante todo o período de serviço ou
dependem da idade do empregado.
O item A1 fornece orientação para sua aplicação. (Incluído pela Revisão CPC 06)
94. Mudanças nas contribuições de empregados ou de terceiros relacionadas ao serviço resultam
em:
(a) custo do serviço corrente e passado (se as mudanças nas contribuições de empregados
não forem estabelecidas nos termos formais do plano e não resultarem de obrigação
construtiva); ou
(b) ganhos e perdas atuariais (se as mudanças nas contribuições de empregados forem
estabelecidas nos termos formais do plano ou resultarem de obrigação construtiva).
94. Para contribuições dos empregados ou de terceiros que são atribuídas aos períodos de serviço
de acordo com o item 93(a), as mudanças nas contribuições resultam em:
(a) custo do serviço corrente e passado (se essas mudanças não forem estabelecidas nos
termos formais do plano e não resultarem de obrigação construtiva); ou
(b) ganhos e perdas atuariais (se essas mudanças forem estabelecidas nos termos formais do
plano ou resultarem de obrigação construtiva). (Alterado pela Revisão CPC 06)
95. Alguns benefícios pós-emprego estão atrelados a variáveis, como o nível de benefícios da
previdência social ou assistência médica governamental. A mensuração de tais benefícios
deve refletir a melhor estimativa dessas variáveis, baseadas no dado histórico e em outra
evidência confiável.
96. As premissas acerca de custos médicos devem levar em consideração as estimativas de
alterações futuras no custo dos serviços médicos que resultem não só da inflação como de
alterações específicas nos custos médicos.
97. A mensuração de benefícios de assistência médica pós-emprego requer a utilização de
premissas acerca do nível e da frequência de sinistros futuros e do custo para a cobertura
desses sinistros. A entidade deve estimar os custos médicos futuros com base em dados
históricos sobre a experiência da própria entidade, adicionado sempre que necessário por
dados históricos de outras entidades, de companhias de seguro, de fornecedores de serviços
médicos ou de outras fontes. As estimativas dos custos médicos futuros devem considerar o
efeito dos avanços tecnológicos, a mudança no uso de assistência médica ou de modelos de
prestação dessa assistência, e de alterações nas condições de saúde dos participantes do plano.
98. O nível e a frequência dos sinistros são particularmente sensíveis à idade, às condições de
saúde e ao sexo dos empregados (e dos seus dependentes) e podem ser sensíveis a outros
fatores, tais como localização geográfica. Portanto, os dados históricos devem ser ajustados na
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medida em que o conjunto demográfico da população diferir daquele utilizado como base de
dados. Esses dados devem ser também ajustados sempre que haja evidência confiável de que
as tendências históricas se modificarão.
Custo do serviço passado e ganhos e perdas na liquidação (settlement)
99. Antes de determinar o custo do serviço passado ou o ganho ou a perda na liquidação, a
entidade deve remensurar o valor líquido de passivo (ativo) de benefício definido usando o
valor justo dos ativos do plano e as premissas atuariais correntes (incluindo taxas de juros de
mercado e outros preços de mercado correntes) que reflitam os benefícios oferecidos em
conformidade com o plano antes de alteração, redução (encurtamento/curtailment) ou
liquidação do plano.
99. Quando determinar o custo do serviço passado ou o ganho ou a perda na liquidação, a
entidade deve remensurar o valor líquido de passivo (ativo) de benefício definido, utilizando o
valor justo dos ativos do plano e as premissas atuariais correntes (incluindo taxas de juros de
mercado e outros preços de mercado correntes) que reflitam:
(a) os benefícios oferecidos em conformidade com o plano e os ativos do plano antes da
alteração, redução (encurtamento/curtailment) ou liquidação do plano; e
(b) os benefícios oferecidos em conformidade com o plano e os ativos do plano após a
alteração, redução ou liquidação do plano. (Alterado pela Revisão CPC 13)
100. A entidade não precisa distinguir entre custo do serviço passado resultante de alteração, custo
do serviço passado resultante de redução (encurtamento/curtailment) e o ganho ou a perda na
liquidação do plano, se essas transações ocorrerem ao mesmo tempo. Em alguns casos, a
alteração no plano ocorre antes da liquidação, como, por exemplo, quando a entidade altera os
benefícios decorrentes do plano e liquida posteriormente os benefícios alterados. Nesses
casos, a entidade deve reconhecer o custo do serviço passado antes de qualquer ganho ou
perda na liquidação.
101. A liquidação ocorre ao mesmo tempo que uma alteração e redução (encurtamento
/curtailment) no plano se o plano for encerrado com o efeito de que a obrigação seja liquidada
e o plano deixe de existir. Entretanto, o encerramento do plano não é uma liquidação se o
plano for substituído por novo plano que ofereça benefícios que sejam, na essência, os
mesmos.
101A. Quando ocorrer alteração, redução ou liquidação do plano, a entidade deve reconhecer e
mensurar o custo do serviço passado, ou o ganho ou a perda na liquidação, de acordo com os
itens 99 a 101 e 102 a 112. Ao fazê-lo, a entidade não deve considerar o efeito do teto de
ativos. A entidade deve então determinar o efeito do teto do ativo após a alteração, redução ou
liquidação do plano e deve reconhecer qualquer alteração nesse efeito, de acordo com o item
57(d). (Incluído pela Revisão CPC 13)
Custo do serviço passado
102. Custo do serviço passado é a mudança no valor presente da obrigação de benefício definido,
resultante de alteração ou redução (encurtamento/curtailment) do plano.
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103. A entidade deve reconhecer o custo do serviço passado como despesa na data em que ocorrer
primeiro entre as seguintes opções:
(a) quando ocorrer a alteração ou a redução (encurtamento/curtailment) do plano; e
(b) quando a entidade reconhecer os custos de reestruturação correspondentes (vide
Pronunciamento Técnico CPC 25 - Provisões, Passivos Contingentes e Ativos
Contingentes) ou os benefícios rescisórios (vide item 165).
104. Alteração no plano ocorre quando a entidade introduz ou cancela plano de benefício definido
ou altera os benefícios devidos em virtude de plano de benefício definido existente.
105. Redução (encurtamento/curtailment) ocorre quando a entidade reduz significativamente o
número de empregados cobertos pelo plano. A redução (encurtamento/curtailment) pode
resultar de evento isolado, tal como o fechamento de fábrica, a descontinuação de operação ou
o encerramento ou suspensão do plano.
106. O custo do serviço passado pode ser tanto positivo (quando benefícios são introduzidos ou
modificados de tal modo que o valor presente da obrigação de benefício definido aumenta)
quanto negativo (quando benefícios são cancelados ou modificados de tal modo que o valor
presente da obrigação de benefício definido diminui).
107. Quando a entidade reduz determinados benefícios a pagar, conforme plano de benefício
definido existente e, ao mesmo tempo, aumenta outros benefícios a pagar, segundo o plano
para os mesmos empregados, a entidade deve tratar a alteração como alteração líquida.
108. O custo do serviço passado exclui:
(a) o efeito das diferenças entre os aumentos reais de salário e o previamente presumido
sobre a obrigação de pagar benefícios referentes a serviços prestados em anos anteriores
(não há custo do serviço passado, porque as premissas atuariais contemplem projeções
salariais);
(b) estimativas, a maior ou a menor, na concessão de aumentos discricionários de benefícios,
quando a entidade tiver obrigação construtiva de conceder tais aumentos (não há custo do
serviço passado, pois as premissas atuariais admitem esses aumentos);
(c) estimativas de melhorias de benefícios resultantes de ganhos atuariais ou do retorno sobre
os ativos do plano que tiverem sido reconhecidos nas demonstrações contábeis, se a
entidade for obrigada, seja pelos termos formais do plano (ou de obrigação construtiva
que vá além desses termos) ou pela legislação, a utilizar qualquer excedente do plano em
benefício dos participantes do plano, mesmo se o aumento de benefício ainda não tiver
sido formalmente concedido (não há custo do serviço passado, pois o aumento resultante
da obrigação é uma perda atuarial; vide item 88); e
(d) o aumento de benefícios com direito adquirido (vested) (ou seja, benefícios que não
dependem de emprego futuro; vide item 72) quando, na ausência de benefícios novos ou
aperfeiçoados, os empregados atenderem aos requisitos de aquisição de direito (não há
custo do serviço passado, pois a entidade reconheceu o custo estimado de benefícios
como custo do serviço corrente, à medida que o serviço foi prestado).
Ganhos e perdas na liquidação
109. O ganho ou a perda na liquidação é a diferença entre:
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(a) o valor presente da obrigação de benefício definido que estiver sendo liquidada, conforme
determinado na data de liquidação; e
(b) o preço de liquidação, incluindo quaisquer ativos do plano transferidos e quaisquer
pagamentos feitos diretamente pela entidade referente à liquidação.
110. A entidade deve reconhecer o ganho ou a perda na liquidação de plano de benefício definido
quando ocorrer a liquidação.
111. A liquidação ocorre quando a entidade celebra a transação que elimina todas as obrigações,
legais ou construtivas, restantes em relação à totalidade ou parte dos benefícios oferecidos
pelo plano de benefício definido (exceto o pagamento de benefícios a empregados, ou em seu
nome, de acordo com os termos do plano e considerado nas premissas atuariais). Por exemplo,
a transferência não recorrente de obrigações significativas do empregador em virtude do plano
a uma companhia seguradora por meio da aquisição de apólice de seguros é uma liquidação; o
pagamento em dinheiro em parcela única, de acordo com os termos do plano, a participantes
do plano em troca de seu direito ao recebimento de benefícios pós-emprego específicos não é
uma liquidação.
112. Em alguns casos, a entidade adquire uma apólice de seguro para custear parte ou a totalidade
dos benefícios aos empregados, referentes ao serviço prestado nos períodos corrente e
anteriores. A aquisição de apólice desse tipo não é uma liquidação se a entidade mantiver a
obrigação legal ou construtiva (vide item 46) de pagar montantes adicionais, se a seguradora
não pagar os benefícios aos empregados, estabelecidos na apólice de seguro. Os itens 116 a
119 estabelecem o reconhecimento e a mensuração dos direitos a reembolsos previstos em
apólices de seguro que não são ativos do plano.
Reconhecimento e mensuração: ativos do plano
Valor justo dos ativos do plano
113. O valor justo de quaisquer ativos do plano deve ser deduzido do valor presente da obrigação
de benefício definido na determinação do déficit ou superávit.
114. Os ativos do plano devem excluir contribuições não pagas, devidas pela entidade
patrocinadora ao fundo de pensão, assim como quaisquer instrumentos financeiros não
transferíveis, emitidos pela entidade e detidos pelo fundo. Os ativos do plano devem ser
reduzidos por quaisquer passivos do fundo que não estão relacionados com benefícios aos
empregados, por exemplo, contas a pagar e outros exigíveis e passivos resultantes dos
instrumentos financeiros derivativos.
115. Quando os ativos do plano incluem apólices de seguro elegíveis, que correspondem
exatamente ao montante e o prazo de partes ou da totalidade dos benefícios devidos do plano,
o valor justo dessas apólices de seguro deve ser considerado como o valor presente das
respectivas obrigações (sujeito a qualquer redução necessária se os montantes a receber,
segundo as apólices de seguro, não forem integralmente recuperáveis).
Reembolsos
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116. Quando, e somente quando, for praticamente certo que a outra parte reembolsará total ou
parcialmente os gastos necessários para liquidar obrigação de benefício definido, a entidade
deve:
(a) reconhecer seu direito ao reembolso como ativo separado. A entidade deve mensurar o
ativo pelo valor justo;
(b) separar e reconhecer as variações no valor justo de seu direito ao reembolso da mesma
forma que para mudanças no valor justo de ativos do plano (vide itens 124 e 125). Os
componentes de custo de benefício definido reconhecidos de acordo com o item 120
podem ser reconhecidos pelo valor líquido dos montantes relativos a variações no valor
contábil do direito ao reembolso.
117. Algumas vezes, a entidade está em condições de procurar outra parte, tal como uma
seguradora, para pagar parte ou a totalidade dos gastos necessários para liquidar uma
obrigação de benefício definido. Apólices de seguro elegíveis, como definidas no item 8, são
ativos do plano. A entidade deve contabilizar apólices de seguro elegíveis da mesma maneira
que os outros ativos do plano e não deve aplicar o item 116 (vide itens 46 a 49 e 115).
118. Quando a apólice de seguro detida pela entidade não é uma apólice de seguro elegível, essa
apólice de seguro não será um ativo do plano. O item 116 é relevante para tais casos: a
entidade reconhece seu direito ao reembolso, de acordo com a apólice de seguro, como ativo
separado e não como dedução, ao determinar o déficit ou superávit do benefício definido. O
item 140(b) exige que a entidade divulgue breve descrição da ligação entre o direito a
reembolso e a respectiva obrigação.
119. Se o direito ao reembolso decorrer de apólice de seguro que corresponde exatamente ao
montante e ao prazo de parte ou totalidade dos benefícios devidos, conforme o plano de
benefício definido, o valor justo do direito de reembolso é considerado como sendo o valor
presente da respectiva obrigação (condicionado a qualquer redução necessária se o reembolso
não for integralmente recuperável).
Componentes de custo de benefício definido
120. A entidade deve reconhecer os componentes de custo de benefício definido, exceto na medida
em que outro pronunciamento exigir ou permitir a sua inclusão no custo do ativo, da seguinte
maneira:
(a) custo do serviço (vide itens 66 a 112) no resultado;
(a) custo do serviço (ver itens 66 a 112 e 122A) no resultado; (Alterada pela Revisão CPC 13)
(b) os juros líquidos sobre o valor líquido de passivo (ativo) de benefício definido (vide itens
123 a 126) no resultado; e
(c) remensurações do valor líquido de passivo (ativo) de benefício definido (vide itens 127 a
130) em outros resultados abrangentes.
121. Outros Pronunciamentos do CPC exigem a inclusão de alguns custos de benefício a
empregados como custo de ativos, tais como estoques e imobilizado (vide CPC 16 e CPC 27).
Quaisquer custos de benefícios pós-emprego incluídos no custo desses ativos devem
considerar a proporção apropriada dos componentes listados no item 120.
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122. Remensurações do valor líquido de passivo (ativo) de benefício definido reconhecidas em
outros resultados abrangentes não devem ser reclassificadas para o resultado no período
subsequente. Contudo, a entidade pode transferir esses montantes reconhecidos em outros
resultados abrangentes dentro do patrimônio líquido.
122A. A entidade deve determinar o custo do serviço atual utilizando as premissas atuariais
determinadas no início do período de relatório anual. No entanto, se a entidade remensurar o
passivo (ativo) líquido de benefício definido, de acordo com o item 99, ela deve determinar o
custo do serviço atual pelo restante do período de relatório anual após a alteração, redução ou
liquidação do plano, utilizando as premissas atuariais utilizadas para remensurar o passivo
(ativo) líquido de benefício definido de acordo com o item 99(b). (Incluído pela Revisão CPC 13)
Juros líquidos sobre o valor líquido de passivo (ativo) de benefício definido
123. Os juros líquidos sobre o valor líquido de passivo (ativo) de benefício definido devem ser
determinados multiplicando-se o valor líquido de passivo (ativo) de benefício definido pela
taxa de desconto especificada no item 83, ambos conforme determinados no início do período
a que se referem as demonstrações contábeis, levando em consideração quaisquer mudanças
no valor líquido de passivo (ativo) de benefício definido durante o período em razão de
pagamentos de contribuições e benefícios.
123. A entidade deve determinar os juros líquidos sobre o valor líquido de passivo (ativo) de
benefício definido, multiplicando o valor líquido de passivo (ativo) de benefício definido pela
taxa de desconto especificada no item 83. (Alterado pela Revisão CPC 13)
123A. Para determinar os juros líquidos de acordo com o item 123, a entidade deve utilizar o
passivo (ativo) líquido de benefício definido e a taxa de desconto determinada no início do
período de relatório anual. No entanto, se a entidade remensurar o passivo (ativo) líquido de
benefício definido, de acordo com o item 99, a entidade deve determinar os juros líquidos
pelo restante do período de relatório anual após a alteração, redução ou liquidação do plano,
utilizando:
(a) o passivo (ativo) líquido de benefício definido determinado, de acordo com o item 99(b);
e
(b) a taxa de desconto utilizada para remensurar o passivo (ativo) líquido de benefício
definido, de acordo com o item 99(b).
Ao aplicar o item 123A, a entidade também deve levar em consideração quaisquer alterações
no passivo (ativo) líquido de benefício definido durante o período resultante de contribuições
ou de pagamentos de benefícios. (Incluído pela Revisão CPC 13)
124. Os juros líquidos sobre o valor líquido de passivo (ativo) de benefício definido podem ser
vistos como compreendendo receita de juros sobre ativos do plano, custo de juros sobre a
obrigação de benefício definido e juros sobre o efeito do teto de ativo (asset ceiling)
mencionado no item 64.
125. A receita de juros sobre ativos do plano é o componente de retorno sobre os ativos do plano e
deve ser determinada multiplicando-se o valor justo dos ativos do plano pela taxa de desconto
especificada no item 83, ambos conforme determinados no início do período a que se referem
as demonstrações contábeis, levando em consideração quaisquer mudanças nos ativos do
plano durante o período em razão de contribuições e pagamentos de benefícios. A diferença
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entre a receita de juros sobre ativos do plano e o retorno sobre ativos do plano deve ser
incluída na remensuração do valor líquido de passivo (ativo) de benefício definido.
125. A receita de juros sobre ativos do plano é o componente de retorno sobre os ativos do plano e
deve ser determinada, multiplicando-se o valor justo dos ativos do plano pela taxa de desconto
especificada no item 123A. A entidade deve determinar o valor justo dos ativos do plano no
início do período de relatório anual. No entanto, se a entidade remensurar o passivo (ativo)
líquido de benefício definido, de acordo com o item 99, a entidade deve determinar a receita
de juros pelo restante do período de relatório anual após a alteração, redução ou liquidação do
plano, considerando os ativos do plano utilizados para remensurar o passivo (ativo) líquido de
benefício definido, de acordo com o item 99(b). Ao aplicar o item 125, a entidade também
deve levar em consideração qualquer alteração nos ativos do plano mantidos durante o
período resultante de contribuições ou de pagamentos de benefícios. A diferença entre a
receita de juros sobre ativos do plano e o retorno sobre ativos do plano deve ser incluída na
remensuração do valor líquido de passivo (ativo) de benefício definido. (Alterado pela Revisão
CPC 13)
126. Os juros sobre o efeito do teto de ativo (asset ceiling) são parte da mudança total no efeito do
teto de ativo (asset ceiling) e são determinados multiplicando-se o efeito do teto de ativo
(asset ceiling) pela taxa de desconto especificada no item 83, ambos conforme determinados
no início do período a que se referem as demonstrações contábeis. A diferença entre esse
montante e a mudança total no efeito do teto de ativo (asset ceiling) deve ser incluída na
remensuração do valor líquido de passivo (ativo) de benefício definido.
126. Os juros sobre o efeito do teto de ativo (asset ceiling) são parte da mudança total no efeito do
teto de ativo (asset ceiling) e devem ser determinados, multiplicando-se o efeito do teto de
ativo (asset ceiling) pela taxa de desconto especificada no item 123A. A entidade deve
determinar o efeito do teto de ativos no início do período de relatório anual. No entanto, se a
entidade remensurar o passivo (ativo) líquido de benefício definido, de acordo com o item 99,
a entidade deve determinar os juros sobre o efeito do teto do ativo pelo restante do período de
relatório anual após a alteração, redução ou liquidação do plano, levando em conta qualquer
alteração no efeito do limite de ativos, determinado de acordo com o item 101A. A diferença
entre os juros sobre o efeito do teto de ativos e a mudança total no efeito do teto de ativo
(asset ceiling) deve ser incluída na remensuração do valor líquido de passivo (ativo) de
benefício definido. (Alterado pela Revisão CPC 13)
Remensurações do valor líquido de passivo (ativo) de benefício definido líquido
127. Remensurações do valor líquido de passivo (ativo) de benefício definido compreendem:
(a) ganhos e perdas atuariais (vide item 128 e 129);
(b) o retorno sobre os ativos do plano (vide item 130), excluindo montantes incluídos nos
juros líquidos sobre o valor líquido de passivo (ativo) de benefício definido (vide item
125); e
(c) qualquer mudança no efeito do teto de ativo (asset ceiling) excluindo montantes incluídos
nos juros líquidos sobre o valor líquido de passivo (ativo) de benefício definido (vide
item 126).
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128. Ganhos e perdas atuariais resultam de aumentos ou reduções no valor presente da obrigação
de benefício definido em razão de mudanças em premissas atuariais e os ajustes pela
experiência. As causas de ganhos e perdas atuariais incluem, por exemplo:
(a) aumentos e reduções inesperadas nas taxas de mortalidade e rotatividade de empregados,
antecipação de aposentadoria ou aumento nos salários, benefícios (se os termos formais
ou construtivos do plano estabelecerem aumentos de benefícios inflacionários) ou custos
médicos;
(b) o efeito de mudanças nas premissas em relação as opções de pagamento de benefícios;
(c) o efeito de mudanças nas estimativas de rotatividade futura de empregados, aposentadoria
antecipada ou mortalidade, ou de aumentos nos salários, benefícios (se os termos formais
ou construtivos do plano estabelecerem aumentos de benefícios inflacionários) ou custos
médicos; e
(d) o efeito de mudanças na taxa de desconto.
129. Os ganhos e as perdas atuariais não devem incluir as alterações no valor presente da obrigação
redução
de benefício definido ocorrido
(encurtamento/curtailment) ou liquidação do plano de benefício definido ou alterações nos
benefícios devidos de acordo com o plano de benefício definido. Referidas alterações
resultam em custo do serviço passado ou em ganhos ou perdas na liquidação.
introdução,
razão da
alteração,
em
130. Na determinação do retorno sobre os ativos do plano, a entidade deve deduzir os custos de
gestão dos ativos do plano e quaisquer impostos devidos pelo próprio plano, exceto impostos
incluídos nas premissas atuariais utilizadas para mensurar a obrigação de benefício definido
(item 76). Outros custos de administração não devem ser deduzidos do retorno sobre os ativos
do plano.
Apresentação
Compensação
131. A entidade pode compensar um ativo referente a um plano com um passivo referente a outro
plano quando, e somente quando, a entidade:
(a) tem o direito legal para utilizar o excedente do plano para liquidar obrigações de outro
plano; e
(b) tem a intenção de liquidar as obrigações em base líquida ou pretende liquidar,
simultaneamente, o excedente do plano contra a obrigação de outro plano.
132. Os critérios de compensação são semelhantes aos estabelecidos para os instrumentos
financeiros no Pronunciamento Técnico CPC 39 - Instrumentos Financeiros: Apresentação.
Distinção entre circulante e não circulante
133. As entidades normalmente distinguem ativos e passivos circulantes de ativos e passivos não
circulantes. Este pronunciamento não especifica se a entidade deve distinguir a parcela
circulante e não circulante de ativos e passivos provenientes de benefícios pós-emprego.
Componente financeiro de custo de benefício definido
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134. O item 120 exige que a entidade reconheça o custo do serviço e os juros líquidos sobre o valor
líquido de passivo (ativo) de benefício definido em resultado. Este Pronunciamento não
especifica como a entidade deve apresentar o custo do serviço e os juros líquidos sobre o
valor líquido de passivo (ativo) de benefício definido. A entidade deve apresentar esses
componentes de acordo com o estabelecido no Pronunciamento CPC 26 – Apresentações das
Demonstrações Contábeis.
Divulgação
135. A entidade deve divulgar informações que:
(a) expliquem as características de seus planos de benefício definido e os riscos a eles
associados (vide item 139);
(b) identifiquem e expliquem os montantes em suas demonstrações contábeis decorrentes de
seus planos de benefício definido (vide itens 140 a 144); e
(c) descrevam como seus planos de benefício definido podem afetar o valor, o prazo e a
incerteza dos fluxos de caixa futuros da entidade (vide itens 145 a 147).
136. Para atingir os propósitos do item 135, a entidade deve considerar todos os seguintes itens:
(a) o nível de detalhamento necessário para atender aos requisitos de divulgação;
(b) o quanto de ênfase se deve dar a cada um dos diversos requisitos;
(c) o quanto de agregação ou desagregação se deve efetuar; e
(d) se os usuários das demonstrações contábeis necessitam de informações adicionais para
avaliar as informações quantitativas divulgadas.
137. Se as divulgações efetuadas de acordo com os requisitos deste Pronunciamento e de outros
Pronunciamentos do CPC forem insuficientes para atingir os objetivos do item 135, a entidade
deve divulgar informações adicionais necessárias para alcançar esses objetivos. Por exemplo,
a entidade pode apresentar uma análise do valor presente da obrigação de benefício definido
que distinga a natureza, as características e os riscos da referida obrigação. Essa divulgação
pode fazer distinção:
(a) entre montantes devidos a participantes ativos, inativos e pensionistas;
(b) entre benefícios com direito adquirido (vested) e benefícios acumulados, mas sem direito
adquirido (not vested);
(c) entre benefícios condicionais, montantes atribuíveis a futuros aumentos salariais e outros
benefícios.
138. A entidade deve avaliar se a totalidade ou parte das divulgações deve ser desagregada para
distinguir planos ou grupos de planos com riscos significativamente diferentes. Por exemplo,
a entidade pode efetuar divulgações desagregadas sobre planos, mostrando uma ou mais das
seguintes características:
(a) diferentes localizações geográficas;
(b) diferentes características, tais como planos de previdência de salário fixo, planos de
previdência de salário final ou planos de assistência médica pós-emprego;
(c) diferentes ambientes regulatórios;
CPC_33(R1)_Rev_21
(d) diferentes segmentos;
(e) diferentes modalidades de financiamento (por exemplo, totalmente não custeado, total
ou parcialmente custeado).
Características dos planos de benefício definido e riscos a eles associados
139. A entidade deve divulgar:
(a) informações sobre as características de seus planos de benefício definido, incluindo:
(i) natureza dos benefícios fornecidos pelo plano (por exemplo, plano de benefício
definido de salário final ou plano baseado em contribuição com garantia);
(ii) descrição da estrutura regulatória na qual o plano opera, como, por exemplo, o nível
de quaisquer requisitos mínimos de custeios, e qualquer efeito da estrutura
regulatória sobre o plano, como, por exemplo, o teto de ativo (asset ceiling) (vide
item 64);
(iii) descrição da responsabilidade de qualquer outra entidade pela governança do plano,
tais como responsabilidades de administradores e conselheiros do plano;
(b) descrição dos riscos aos quais o plano expõe a entidade, voltada para quaisquer riscos
incomuns, específicos da entidade ou específicos do plano, e de quaisquer concentrações
de risco significativas. Por exemplo, se os ativos do plano estiverem investidos
principalmente em uma classe de investimentos, como, por exemplo, imóveis, o plano
poderá expor a entidade a uma concentração de risco do mercado imobiliário;
(c) descrição de quaisquer alterações, redução (encurtamento/curtailment) e liquidações do
plano.
Explicação de valores das demonstrações contábeis
140. A entidade deve fornecer uma conciliação entre o saldo de abertura e o saldo de fechamento
para cada um dos itens a seguir, se aplicáveis:
(a) o valor líquido de passivo (ativo) de benefício definido, apresentando conciliações
separadas para:
(i) ativos do plano;
(ii) o valor presente da obrigação de benefício definido;
(iii) o efeito do teto de ativo (asset ceiling);
(b) quaisquer direitos a reembolso. A entidade deve também apresentar a relação entre
qualquer direito a reembolso e a obrigação correspondente.
141. Cada conciliação listada no item 140 deve apresentar cada um dos itens a seguir, se
aplicáveis:
(a) custo do serviço corrente;
(b) receita ou despesa de juros;
(c) remensurações do valor líquido de passivo (ativo) de benefício definido líquido,
apresentando separadamente:
(i) o retorno sobre os ativos do plano, excluindo valores de juros considerados em (b);
CPC_33(R1)_Rev_21
(ii) ganhos e perdas atuariais decorrentes de mudanças nas premissas demográficas (ver
item 76(a));
(iii) ganhos e perdas atuariais decorrentes de mudanças nas premissas financeiras (ver
item 76(b));
(iv) mudanças no efeito limitador de ativo de benefício definido líquido ao teto de ativo
(asset ceiling), excluindo valores de juros considerados em (b). A entidade deve
divulgar também como determinou o benefício econômico máximo disponível, ou
seja, se esses benefícios seriam na forma de reembolso, reduções nas contribuições
futuras ou a combinação de ambas;
(d) custo do serviço passado e ganhos e perdas resultantes de liquidações. Conforme permite
o item 100, o custo do serviço passado e ganhos e perdas decorrentes de liquidações não
precisam ser destacados se estes ocorrerem de forma simultânea;
(e) o efeito de mudanças nas taxas de câmbio;
(f) contribuições feitas para o plano, apresentando separadamente aquelas efetuadas pelo
empregador e pelos participantes do plano;
(g) pagamentos provenientes do plano, apresentando separadamente o montante pago
referente a quaisquer liquidações;
(h) os efeitos de combinações e alienações de negócios.
142. A entidade deve alocar o valor justo dos ativos do plano em classes que distingam a natureza
e o risco desses ativos, subdividindo cada classe de ativos do plano entre aquelas que possuem
valor de mercado cotado em mercado ativo (tal como definido no CPC 46 – Mensuração do
Valor Justo) e aquelas que não têm. Por exemplo, considerando-se o nível de divulgação
requerido no item 136, a entidade pode distinguir entre:
(a) caixa e equivalentes de caixa;
(b) instrumentos patrimoniais (segregados por tipo de setor, porte da empresa, geografia,
etc.);
(c) instrumentos de dívida (segregados por tipo de emissor, qualidade do crédito, geografia,
etc.);
(d) imóveis (segregados por geografia, etc.);
(e) instrumentos derivativos (segregados por tipo de risco subjacente especificado em
contrato, por exemplo, contratos de taxa de juros, contratos de câmbio, contratos de
ações, contratos de crédito, swaps de longevidade, etc.);
(f) fundos de investimento (segregados por tipo de fundo);
(g) títulos lastreados em ativos; e
(h) dívida estruturada.
143. A entidade deve divulgar o valor justo dos instrumentos financeiros de sua própria emissão
mantidos como ativos do plano e o valor justo de ativos do plano que sejam imóveis ocupados
pela entidade ou outros ativos por ela utilizados.
144. A entidade deve divulgar as premissas atuariais significativas utilizadas para determinar o
valor presente da obrigação de benefício definido (vide item 76). Referida divulgação deve
ser em termos absolutos (por exemplo, como porcentagem absoluta, e não apenas como
CPC_33(R1)_Rev_21
margem entre diferentes porcentagens ou outras variáveis). Quando a entidade elaborar
divulgações totais por agrupamento de planos, ela deve fornecer essas divulgações na forma
de médias ponderadas ou na forma de faixas restritas.
Montante, prazo e incerteza de fluxos de caixa futuros
145. A entidade deve divulgar:
(a) análise de sensibilidade para cada premissa atuarial significativa (divulgadas em
conformidade com o item 144) no final do período a que se referem as demonstrações
contábeis, demonstrando como a obrigação de benefício definido teria sido afetada por
mudanças em premissa atuarial relevante que eram razoavelmente possíveis naquela data;
(b) métodos e premissas utilizados na elaboração das análises de sensibilidade exigidas por
(a) e as limitações desses métodos;
(c) mudanças, em relação ao período anterior, nos métodos e premissas utilizados na
elaboração das análises de sensibilidade e as razões dessas mudanças.
146. A entidade deve divulgar uma descrição de quaisquer estratégias de confrontação de
ativos/passivos utilizadas pelo plano ou pela entidade patrocinadora, incluindo o uso de
anuidades e outras técnicas, tais como swaps de longevidade, para gerenciamento do risco.
147. Para fornecer uma indicação do efeito do plano de benefício definido sobre os seus fluxos de
caixa futuros, a entidade deve divulgar:
(a) descrição de quaisquer acordos de custeio e política de custeamento que afetem
contribuições futuras;
(b) contribuições esperadas ao plano para o próximo período das demonstrações contábeis;
(c) informações sobre o perfil de vencimento da obrigação de benefício definido. Isto inclui a
duração média ponderada da obrigação de benefício definido e pode incluir outras
informações sobre os prazos de distribuição de pagamentos de benefícios, tais como uma
análise de vencimentos dos pagamentos de benefícios.
Planos multiempregadores
148. Caso participe de plano de benefício definido multiempregador, a entidade deve divulgar:
(a) descrição dos acordos de custeio, incluindo o método utilizado para determinar a taxa de
contribuições da entidade e quaisquer requisitos mínimos de custeio;
(b) descrição da medida em que a entidade pode ser responsável perante o plano por
obrigações de outras entidades, em conformidade com os termos e condições do plano
multiempregador;
(c) descrição de qualquer alocação convencionada de déficit ou superávit sobre:
(i) o encerramento do plano; ou
(ii) a saída do plano por parte da entidade;
(d) caso a entidade contabilize esse plano como se este fosse plano de contribuição definida
de acordo com o item 34, a entidade deve divulgar o seguinte, complementarmente às
informações exigidas por (a) a (c), ao invés das informações exigidas pelos itens 139 a
147:
CPC_33(R1)_Rev_21
(i) o fato de que o plano é um plano de benefício definido;
(ii) a razão pela qual não estão disponíveis informações suficientes para permitir que a
entidade contabilize o plano como um plano de benefício definido;
(iii) as contribuições esperadas para o plano para o próximo período das demonstrações
contábeis;
(iv) informações sobre qualquer déficit ou superávit no plano que possa afetar o valor de
contribuições futuras, incluindo a base utilizada para determinar o déficit ou
superávit e as implicações, se houver, para a entidade;
(v) uma indicação do nível de participação da entidade no plano em comparação com
outras entidades participantes. Exemplos de medidas que podem fornecer essa
indicação incluem a proporção da entidade sobre as contribuições totais ao plano ou
a proporção da entidade sobre o número total de participantes ativos, participantes
aposentados e antigos participantes com direito a benefícios, se essas informações
estiverem disponíveis.
Planos de benefício definido que compartilham riscos entre várias entidades sob controle
comum
149. Caso a entidade participe de plano de benefício definido que compartilhar os riscos entre
entidades sob controle comum, ela deve divulgar:
(a) o acordo contratual ou política conveniada para a cobrança do custo líquido de benefício
definido ou o fato de que referida política não exista;
(b) a política de determinação da contribuição a ser paga pela entidade;
(c) se a entidade contabilizar uma alocação do custo líquido de benefício definido, conforme
indicado no item 41, todas as informações sobre o plano como um todo exigidas pelos
itens 135 a 147;
(d) se a entidade contabilizar a contribuição a pagar no período, conforme indicado no item
41, as informações sobre o plano como um todo exigidas pelos itens 135 a 137, 139, 142
a 144 e 147(a) e (b).
150. As informações exigidas pelo item 149(c) e (d) podem ser divulgadas por meio de referência
cruzada com divulgações nas demonstrações contábeis de outra entidade de grupo se:
(a) as demonstrações contábeis desse grupo de entidade identificarem e divulgarem
separadamente as informações exigidas sobre o plano; e
(b) as demonstrações contábeis desse grupo de entidade estiverem disponíveis a usuários
das demonstrações contábeis sob os mesmos termos que as demonstrações contábeis da
entidade e ao mesmo tempo, ou antes, que as demonstrações contábeis da entidade.
Requisitos de divulgação em outros Pronunciamentos
151. Quando exigido pelo Pronunciamento CPC 05 – Divulgação sobre Partes Relacionadas, a
entidade deve divulgar informações sobre:
(a) transações com partes relacionadas com planos de benefícios pós-emprego; e
(b) benefícios pós-emprego para o pessoal-chave da administração.
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152. Quando exigido pelo Pronunciamento CPC 25 – Provisões, Passivos Contingentes e Ativos
Contingentes, a entidade deve divulgar informações sobre passivos contingentes decorrentes
de obrigações de benefícios pós-emprego.
Outros benefícios de longo prazo a empregados
153. Outros benefícios de longo prazo a empregados incluem itens como, por exemplo, os
seguintes, se a entidade não espera que sejam integralmente liquidados em até doze meses
após o período a que se referem as demonstrações contábeis em que os empregados prestarem
os respectivos serviços:
(a) ausências remuneradas de longo prazo, como, por exemplo, licença por tempo de serviço
ou licença sabática;
(b) jubileu ou outros benefícios por tempo de serviço;
(c) benefícios de invalidez de longo prazo;
(d) participação nos lucros e bônus; e
(e) remuneração diferida.
154. A mensuração de outros benefícios de longo prazo a empregados não está normalmente
sujeita ao mesmo grau de incerteza que a mensuração de benefícios pós-emprego. Por essa
razão, este Pronunciamento requer um método simplificado de contabilização no caso de
outros benefícios de longo prazo a empregados. Diferentemente da contabilização exigida
para benefícios pós-emprego, esse método não deve reconhecer remensurações em outros
resultados abrangentes.
Reconhecimento e mensuração
155. Ao reconhecer e mensurar o superávit ou déficit em outro plano de benefícios de longo prazo
a empregados, a entidade deve aplicar os itens 56 a 98 e 113 a 115. A entidade deve aplicar os
itens 116 a 119 no reconhecimento e mensuração de qualquer direito a reembolso.
156. Para outros benefícios de longo prazo a empregados, a entidade deve reconhecer o montante
líquido dos seguintes valores no resultado, exceto se outro pronunciamento exigir ou permitir
a inclusão no custo de ativo:
(a) custo do serviço (vide itens 66 a 112);
(a) custo do serviço (ver itens 66 a 112 e 122A); (Alterada pela Revisão CPC 13)
(b) juros líquidos sobre o valor líquido de passivo (ativo) de benefício definido (vide itens
123 a 126); e
(c) remensurações do valor líquido de passivo (ativo) de benefício definido (vide itens 127 a
130).
157. Uma forma de outros benefícios de longo prazo a empregados é o benefício de invalidez de
longo prazo. Se o nível de benefício depender do tempo de serviço, a obrigação surge a partir
da prestação do serviço. A mensuração dessa obrigação reflete a probabilidade de que o
pagamento venha a ser exigido e a duração de tempo pela qual se espera que o pagamento seja
inválido,
feito. Se o nível de benefício for o mesmo para qualquer empregado
CPC_33(R1)_Rev_21
independentemente do tempo de serviço, o custo esperado desses benefícios é reconhecido
quando o evento que gera o benefício de longo prazo de invalidez ocorrer.
Divulgação
158. Embora este Pronunciamento não exija divulgações específicas sobre outros benefícios de
longo prazo aos empregados, outros Pronunciamentos do Comitê de Pronunciamentos
Contábeis podem requerer tais divulgações. Por exemplo, o Pronunciamento CPC 05 –
Divulgação sobre Partes Relacionadas requer divulgações sobre benefícios a empregados para
os administradores da entidade. O Pronunciamento CPC 26 – Apresentação das
Demonstrações Contábeis requer a divulgação das despesas de benefícios a empregados.
Benefícios rescisórios
159. Este Pronunciamento trata de benefícios rescisórios separadamente de outros benefícios a
empregados, porque o evento gerador da obrigação é a rescisão do contrato de trabalho e não
a prestação do serviço pelo empregado. Benefícios rescisórios resultam da decisão da entidade
de rescindir o contrato de trabalho ou da decisão do empregado de aceitar uma oferta de
benefícios por parte da entidade em troca da rescisão do contrato de trabalho.
160. Benefícios rescisórios não incluem benefícios aos empregados decorrentes da rescisão do
contrato de trabalho a pedido do empregado sem uma oferta da entidade ou como resultado de
aposentadoria compulsória, uma vez que esses benefícios são benefícios pós-emprego.
Algumas entidades fornecem um nível menor de benefício para rescisão do contrato de
trabalho a pedido do empregado (na essência, benefício pós-emprego) do que para a rescisão
do contrato de trabalho a pedido da entidade. A diferença entre o benefício fornecido pela
rescisão do contrato de trabalho a pedido do empregado e o benefício maior fornecido por
rescisão a pedido da entidade constitui benefício rescisório.
161. A forma do benefício ao empregado não determina se ele é fornecido em troca de serviço ou
em troca da rescisão do contrato de trabalho do empregado. Benefícios rescisórios são
tipicamente pagamentos em parcela única, mas, algumas vezes, incluem também:
(a) melhoria de benefícios pós-emprego, seja indiretamente, por meio de plano de benefícios
aos empregados, ou diretamente;
(b) salário até o final do período de aviso específico, se o empregado não mais prestar
serviços que proporcionem benefícios econômicos à entidade.
162. Indicadores de que um benefício a empregados é fornecido em troca de serviços incluem os
seguintes:
(a) o benefício depende da prestação de serviços futuros (incluindo benefícios que aumentam
se serviços adicionais forem prestados);
(b) o benefício é fornecido de acordo com os termos de plano de benefícios a empregados.
163. Alguns benefícios rescisórios são fornecidos de acordo com os termos de plano de benefícios
a empregados existente. Por exemplo, eles podem ser especificados por lei, pelo contrato de
trabalho ou por acordo sindical, ou podem ser implícitos como resultado da prática passada da
entidade de fornecer benefícios similares. Como outro exemplo, se a entidade disponibiliza
uma oferta de benefícios, por mais do que um curto período, ou se exista mais do que um
CPC_33(R1)_Rev_21
curto período entre a oferta e a data esperada de efetiva rescisão, a entidade considera se
estabeleceu novo plano de benefícios aos empregados e, assim, se os benefícios oferecidos em
razão desse plano são benefícios rescisórios ou benefícios pós-emprego. Benefícios a
empregados fornecidos de acordo com os termos de plano de benefícios a empregados são
benefícios rescisórios se resultarem da decisão da entidade de rescindir o contrato de trabalho
do empregado e não dependerem da prestação de serviços futuros.
164. Alguns benefícios a empregados são fornecidos
independentemente do motivo do
desligamento do empregado. O pagamento desses benefícios é certo (sujeito a quaisquer
requisitos de aquisição de direito ou de serviço mínimo), mas o momento desse pagamento é
incerto. Embora esses benefícios sejam descritos, em alguns países, como indenizações
rescisórias ou gratificações por desligamento, eles são benefícios pós-emprego, e não
benefícios rescisórios, e a entidade deve contabilizá-los como benefícios pós-emprego.
Reconhecimento
165. A entidade deve reconhecer um passivo e uma despesa com benefícios rescisórios no
momento que ocorrer primeiro dentre as seguintes datas:
(a) quando a entidade não mais puder cancelar a oferta desses benefícios; e
(b) quando a entidade reconhecer os custos de reestruturação que estiver no alcance do
Pronunciamento CPC 25 – Provisões, Passivos Contingentes e Ativos Contingentes e
envolver o pagamento de benefícios rescisórios.
166. Para benefícios rescisórios devidos em razão da decisão do empregado de aceitar uma oferta
de benefícios em troca da rescisão do contrato de trabalho, o momento em que a entidade não
pode mais cancelar a oferta desses benefícios é a data que ocorrer primeiro dentre as seguintes
opções:
(a) quando o empregado aceita a oferta;
(b) quando uma restrição (por exemplo, exigência legal, regulatória ou contratual ou outra
restrição) sobre a capacidade da entidade de cancelar a oferta passar a ter efeito. Isto se
daria no momento em que a oferta fosse feita, se a restrição existisse no momento da
oferta.
167. Para benefícios rescisórios devidos como resultado da decisão da entidade em rescindir o
contrato de trabalho do empregado, a entidade não pode mais cancelar a oferta quando tiver
comunicado aos empregados afetados um plano de rescisão que atenda a todos os critérios
seguintes:
(a) as medidas necessárias para a conclusão do plano indicam ser improvável que serão feitas
mudanças significativas no plano;
(b) o plano identifica o número de empregados cujo contrato de trabalho deve ser rescindido,
suas classificações de cargo ou funções e suas localizações (mas o plano não necessita
identificar cada empregado individualmente) e a data de conclusão esperada;
(c) o plano estabelece os benefícios rescisórios que os empregados receberão, em detalhes
suficientes de forma que os empregados possam determinar o tipo e o montante dos
benefícios que receberão quando seu contrato de trabalho for rescindido.
CPC_33(R1)_Rev_21
168. Quando a entidade reconhecer benefícios rescisórios, ela pode ter também a necessidade de
contabilizar uma alteração ou redução (encurtamento/curtailment) em outros benefícios a
empregados (vide item 103).
Mensuração
169. A entidade deve mensurar benefícios rescisórios no reconhecimento inicial, mensurando e
reconhecendo mudanças subsequentes, de acordo com a natureza do benefício a empregados,
ficando evidente que os benefícios rescisórios são uma melhoria de benefícios pós-emprego, a
entidade deve aplicar os requisitos para benefícios pós-emprego. Do contrário:
(a) se a entidade espera que os benefícios rescisórios sejam integralmente liquidados em até
doze meses após o período a que se referem as demonstrações contábeis em que o
benefício rescisório for reconhecido, ela deve aplicar os requisitos para benefícios de
curto prazo a empregados;
(b) se a entidade não espera que os benefícios rescisórios sejam integralmente liquidados em
até doze meses após o período a que se referem as demonstrações contábeis, a entidade
deve aplicar os requisitos para outros benefícios de longo prazo a empregados.
170. Dado que benefícios rescisórios não são fornecidos em troca de serviços, os itens 70 a 74
relativos à atribuição do benefício a períodos de serviço não são relevantes.
Exemplo ilustrativo dos itens 159 a 170
Contexto
Em virtude de aquisição recente, a entidade planeja fechar uma fábrica dentro de dez meses
e, naquela ocasião, rescindir os contratos de trabalho de todos os empregados restantes da
fábrica. Como necessita do conhecimento dos empregados da fábrica para cumprir alguns
contratos, a entidade anuncia um plano de rescisão, nos seguintes termos.
Cada empregado que permanecer e prestar serviços até o fechamento da fábrica receberá, na
data do desligamento, o pagamento em dinheiro de $ 30.000. Empregados que saírem antes
do fechamento da fábrica receberão $ 10.000.
A fábrica possui 120 empregados. No momento do anúncio do plano, a entidade espera que
20 deles saiam antes do fechamento. Portanto, as saídas de caixas totais esperadas em
virtude do plano são de $ 3.200.000 (ou seja, 20 * $ 10.000 + 100 * $ 30.000). Conforme
exige o item 160, a entidade deve contabilizar benefícios fornecidos em troca da rescisão do
contrato de trabalho como benefícios rescisórios, e contabilizar benefícios fornecidos em
troca de serviços como benefícios de curto prazo aos empregados.
Benefícios rescisórios
O benefício fornecido em troca da rescisão dos contratos de trabalho é de $ 10.000. Este é o
valor que a entidade teria de pagar ao rescindir os contratos de trabalho, independentemente
de os empregados permanecerem e prestarem serviços até o fechamento da fábrica ou saírem
antes do seu fechamento. Embora os empregados possam sair antes do fechamento da
fábrica, a rescisão do contrato de trabalho de todos os empregados é resultado da decisão da
entidade de fechar a fábrica e dispensar seus empregados (ou seja, todos os empregados
CPC_33(R1)_Rev_21
deixarão o emprego quando a fábrica for fechada). Portanto, a entidade reconhece um
passivo de $ 1.200.000 (ou seja, 120 * $ 10.000) pelos benefícios rescisórios fornecidos de
acordo com o plano de benefícios aos empregados quando o plano de rescisão for anunciado
ou quando a entidade reconhecer os custos de reestruturação associados ao fechamento da
fábrica, na data que ocorrer primeiro.
Benefícios fornecidos em troca de serviços
Os benefícios adicionais que os empregados receberão se prestarem serviços durante todo o
período de dez meses são obtidos em troca de serviços prestados ao longo desse período.
Estes benefícios devem ser contabilizados pela entidade como benefícios de curto prazo aos
empregados porque espera liquidá-los em até doze meses após o período a que se referem as
demonstrações contábeis. Neste exemplo, o desconto a valor presente não é necessário, de
modo que a despesa de $ 200.000 (ou seja, $ 2.000.000 ÷ 10) é reconhecida a cada mês
durante o período de serviço de dez meses, com o correspondente aumento no valor contábil
do passivo.
Divulgação
171. Embora este Pronunciamento não exija divulgações específicas sobre benefícios rescisórios,
outros Pronunciamentos emitidos pelo CPC podem exigir tais divulgações. Por exemplo, o
Pronunciamento CPC 05 – Divulgação sobre Partes Relacionadas exige divulgações sobre os
benefícios rescisórios de administradores da entidade. O Pronunciamento CPC 26 –
Apresentação das Demonstrações Contábeis exige a divulgação das despesas de benefícios
aos empregados.
Disposições transitórias
172. Este Pronunciamento substitui o Pronunciamento Técnico CPC 33 – Benefícios a Empregados
aprovado pelo Comitê de Pronunciamentos Contábeis em 4 de setembro de 2009.
173. A entidade deve aplicar este Pronunciamento de forma retrospectiva, de acordo com o
Pronunciamento CPC 23 – Políticas Contábeis, Mudança de Estimativa e Retificação de Erro,
exceto nas seguintes situações:
(a) a entidade não precisa ajustar o valor contábil de ativos não alcançados por este
Pronunciamento em razão das mudanças em custos de benefícios a empregados que
foram incluídos no valor contábil antes da data de aplicação inicial. A data de aplicação
inicial é o início do período anterior mais antigo apresentado na primeira demonstração
contábil em que a entidade adotar este Pronunciamento;
(b) em demonstrações contábeis referentes a exercícios sociais iniciados antes de 1º de
janeiro de 2014, a entidade não precisa apresentar informações comparativas para as
divulgações exigidas pelo item 145 sobre a sensibilidade da obrigação de benefício
definido.
174 a 176. (Eliminados).
177. A entidade deve aplicar as alterações a este pronunciamento desde o início do primeiro
período comparativo apresentado nas demonstrações contábeis nas quais a entidade aplicar
CPC_33(R1)_Rev_21
essas alterações. Qualquer ajuste decorrente da aplicação das alterações deve ser reconhecido
em resultados acumulados no início desse período. (Incluído pela Revisão CPC 08)
178 A Revisão de Pronunciamentos Técnicos nº 21, aprovada pelo CPC em 4 de novembro de
2022, alterou a nota de rodapé do item 8. A entidade deve aplicar essas alterações quando
aplicar o CPC 50. (Incluído pela Revisão de Pronunciamentos Técnicos n.º 21)
CPC_33(R1)_Rev_21
Apêndice A – Guia de Aplicação (Incluído pela Revisão CPC 06)
Este Apêndice é parte integrante do Pronunciamento. Ele descreve a aplicação dos itens 92 e 93 e
tem a mesma autoridade de outras partes do Pronunciamento.
A1. Os requerimentos contábeis para as contribuições advindas dos empregados e de terceiros são
ilustradas no diagrama abaixo.
Contribuições de empregados ou de terceiros
Estabelecidos nos termos formais do plano (ou surgem de
obrigação construtiva que vá além desses termos)
Discricionário
Atreladas ao serviço
Não atreladas ao
serviço (por exemplo,
redução de déficit)
Depende do
número de
anos de serviço
Independe do
número de anos
de serviço
(1)
Redução do custo
do serviço
atribuído a
períodos de
serviço (item 93
(a))
Redução do custo
do serviço no
período em que o
serviço seja
prestado (item 93
(b))
Afetam novas
mensurações (item
93)
Redução do custo do
serviço, mediante o
pagamento do plano
(item 92)
(1) A seta pontilhada significa que a entidade pode optar.
CPC_33(R1)_Rev_21
Business
Combinations
Handbook
US GAAP
July 2021
_____
kpmg.com/us/frv
Contents
Preface
.............................................................................................................. 1
1. Scope .............................................................................................................. 4
2. Identifying a Business Combination ................................................................ 14
3. The Acquisition Method .................................................................................. 87
4. Identifying the Acquirer ................................................................................... 88
5. Determining the Acquisition Date ................................................................. 108
6. Recognizing and Measuring the Consideration Transferred .......................... 113
7. Recognizing and Measuring the Identifiable Assets Acquired, the Liabilities
Assumed, and Any Noncontrolling Interest in the Acquiree ............. 161
8. Recognizing and Measuring Goodwill or a Gain from a Bargain Purchase .... 240
9. Additional Guidance for Applying the Acquisition Method to Particular
Types of Business Combinations ..................................................... 247
10. Measurement Period .................................................................................. 267
11. Determining What Is Part of the Business Combination Transaction ......... 285
12. Subsequent Measurement and Accounting ................................................ 348
13. Disclosures ................................................................................................. 369
14. Effective Date and Transition ...................................................................... 388
15. Noncontrolling Interests in Consolidated Financial Statements .................. 392
See KPMG Handbook, Consolidation, for details on the subsequent accounting for
noncontrolling interests
SECTIONS 16 THROUGH 21
FAIR VALUE MEASUREMENTS
16. Overview of ASC Subtopic 820-10 .............................................................. 393
17. Determining the Fair Value of Assets Acquired and
Liabilities Assumed in a Business Combination ................................ 431
18. Determining the Fair Value of the Consideration
Transferred in a Business Combination ............................................ 492
19. Determining the Fair Value of a Noncontrolling Interest
in a Business Combination ................................................................ 505
20. Determining the Fair Value of a Previously Held Equity
Interest in a Business Combination .................................................. 508
21. Not used
22. Goodwill and Other Intangible Assets ......................................................... 512
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i
Contents
SECTIONS 23 THROUGH 25
INCOME TAX CONSIDERATIONS
23. The Tax Effects of Business Combinations ................................................ 534
See KPMG Handbook, Accounting for Income Taxes, Section 6, The Tax Effects of Business
Combinations
24. The Tax Effects of Changes in Ownership Interests While
Retaining Control .............................................................................. 535
See KPMG Handbook, Accounting for Income Taxes, Section 6, The Tax Effects of Business
Combinations
25. The Tax Effects of Asset Acquisitions ........................................................ 536
See KPMG Handbook, Accounting for Income Taxes, Section 10, Other Considerations
26. Private Company and Not-for-Profit Accounting Alternatives ...................... 537
27. Application of Pushdown Accounting ......................................................... 548
28. Combinations of Entities Under Common Control ...................................... 573
KPMG Financial Reporting View ...................................................................... 599
Acknowledgments ............................................................................................ 601
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ii
Preface
July 2021
The purpose of KPMG Handbooks is to assist you in understanding the application of US
GAAP in practice, and to explain the conclusions that we have reached on many
interpretive issues.
Business Combinations is designed to assist you in understanding the application of:
• FASB ASC Topic 805, Business Combinations; and
• Certain subsections of FASB ASC Topic 350, IntangiblesGoodwill and
Other.
We expect to update this Handbook as needed based on developments in practice. You
will always be able to find the most up-to-date version of this and other KPMG
publications, including KPMG Handbook, Asset acquisitions, on KPMG Financial
Reporting View.
Currently Effective Requirements
Each section of this Handbook includes excerpts from the FASB’s Accounting Standards
Codification® to supplement our interpretive guidance, and illustrative examples that
address the specific implementation issues we have identified.
Section 26 discusses the accounting alternatives available only to private companies and
not-for-profit entities.
Pending Content
This Handbook incorporates the following Accounting Standards Updates that are
effective for some or all entities for fiscal periods beginning after December 15, 2018 and
certain others that allow for early adoption. This includes:
• ASU 2014-09, Revenue from Contracts with Customers, and related
amendments
• ASU 2016-02, Leases, and related amendments
• ASU 2016-10, Identifying Performance Obligations and Licensing
• ASU 2017-04, Simplifying the Test for Goodwill Impairment
• ASU 2017-05, Clarifying the Scope of Asset Derecognition Guidance and
Accounting for Partial Sales of Nonfinancial Assets
• ASU 2018-07, Improvements to Nonemployee Share-Based Payment
Accounting
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1
Preface
• ASU 2019-06, Extending the Private Company Accounting Alternatives on
Goodwill and Certain Identifiable Intangible Assets to Not-for-Profit Entities
• ASU 2019-10, Effective Dates
• ASU 2020-05, Effective Dates for Certain Entities
• ASU 2020-06, Accounting for Convertible Instruments and Contracts in an
Entity’s Own Equity
• ASU 2021-03, Accounting Alternative for Evaluating Triggering Events
New in 2021
In 2021, we have updated or added the following significant guidance in this Handbook.
Topic
Reference
Clarify accounting for arrangements between employees and
selling shareholders
11.021a
Clarify recognition by an acquiree of the effects of an
acceleration of awards when a change in control provision is
triggered
11.038-11.040
Acceleration of awards with a change in control and a
secondary event (double trigger)
11.041-11.041a
Clarify accounting for an acquirer’s subsequent grant of awards
when acquirer did not exchange acquiree’s awards in the
business combination transaction
11.055a
Additional guidance on adjustments for supplemental pro forma
information disclosures for public entities
13.009
Removed guidance superseded by SEC Release No. 33-10786,
Amendments to Financial Disclosures about Acquired and
Disposed Businesses, included in other publications
Section 13
Clarify guidance for costs related to combination of entities
under common control
28.022
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2
Preface
Abbreviations
The following abbreviations are used in this Handbook.
ASC
ASU
CAC
FASB’s Accounting Standards Codification®
Accounting Standards Update
Contributory asset charges
EBITDA
Earnings before interest, taxes, depreciation and amortization
EITF
EPS
GAAP
IPO
IPR&D
IRR
LIFO
LTCC
Emerging Issues Task Force
Earnings per share
Generally accepted accounting principles
Initial public offering
In-process research and development
Implied rate of return
Last-in, first-out
Long-term construction-type contracts
MPEEM
Multi-period excess earnings method
NCI
NFP
OCI
OPM
PCS
PFI
R&D
REIT
SBM
SEC
VIE
Noncontrolling interest(s)
Not-for-profit
Other comprehensive income
Option pricing method
Postcontract customer support
Projected financial information
Research and development
Real estate investment trust
Scenario based method
Securities and Exchange Commission
Variable interest entity
WACC
WARA
Weighted-average cost of capital
Weighted-average return on assets
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3
Section 1 - Scope
Detailed Contents
Business Combinations
Variable Interest Entities
When a Variable Interest Entity and its Primary Beneficiary Are under Common
Control
Mutual Entities
Leveraged Buyout Transactions
Transactions outside the Scope of ASC Topic 805
The Formation of a Joint Venture
The Acquisition of an Asset or a Group of Assets That Do Not Constitute a Business
A Combination between Entities or Businesses under Common Control
A Combination between Not-for-Profit Organizations or the Acquisition of a For-Profit
Business by a Not-for-Profit Organization
Financial Assets and Financial Liabilities of a Collateralized Financing Entity
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1. Scope
1.000 ASC Topic 805, Business Combinations, establishes the accounting and reporting
for business combinations. ASC Topic 805 defines a business combination, and requires
accounting for each business combination within the scope of ASC Topic 805 by the
acquisition method. See discussion of The Acquisition Method in Section 3. In addition,
ASC Subtopic 805-50, Business Combinations - Related Issues, provides guidance on
transactions that may be similar to business combinations but that do not meet the
requirements to be accounted for as a business combination, such as combinations of
entities under common control. See Section 28 for additional discussion of combinations
of entities under common control.
1.000a Other than for limited exceptions provided in ASC Topic 805, assets acquired,
liabilities assumed or incurred, and equity instruments issued in a business combination
are recognized and measured at fair value at the acquisition date and, following the
acquisition, are accounted for based on other applicable generally accepted accounting
principles (GAAP).
ASC Paragraph 805-10-15-3
The guidance in the Business Combinations Topic applies to all transactions or
other events that meet the definition of a business combination or an acquisition
by a not-for-profit-entity.
ASC Paragraph 805-10-15-4
The guidance in the Business Combinations Topic does not apply to any of the
following:
(a) The formation of a joint venture
(b) The acquisition of an asset or a group of assets that does not constitute a
business or a nonprofit activity
(c) A combination between entities, businesses, or nonprofit activities under
common control (see paragraph 805-50-15-6 for examples)
(d) An acquisition by a not-for-profit entity for which the acquisition date is
before December 15, 2009 or a merger of not-for-profit entities (NFPs)
(e) A transaction or other event in which an NFP obtains control of a not-for-
profit entity but does not consolidate that entity, as described in ASC
paragraph 958-810-25-4. The Business Combinations Topic also does not
apply if an NFP that obtained control in a transaction or other event in which
consolidation was permitted but not required decides in a subsequent annual
reporting period to begin consolidating a controlled entity that it initially
chose not to consolidate.
(f) Financial assets and financial liabilities of a consolidated variable interest
entity that is a collateralized financing entity within the scope of the guidance
on collateralized financing entities in [ASC] Subtopic 810-10.
1.001 ASC Topic 805 represents the codification of FASB Statement 141(R), Business
Combinations, which replaced FASB Statement No. 141, Business Combinations, and
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5
1. Scope
required prospective application to business combinations for which the acquisition date
occurs in an annual reporting period beginning on or after December 15, 2008. Early
application was prohibited.
BUSINESS COMBINATIONS
1.002 A business combination in ASC Topic 805 includes all transactions or events in
which an acquirer obtains control of one or more businesses, regardless of how it obtains
control or how the consideration is transferred. Thus, transactions in which an acquirer
obtained control of a business through means other than an acquisition of net assets or
equity interests are included in the scope of ASC Topic 805. For example, under ASC
Topic 805, a business combination can occur on the lapse of minority veto rights that
previously kept an acquirer who held a majority voting interest from controlling an
acquiree. See discussion of Control in Section 2. Additionally, the acquisition of a
business through a nonmonetary exchange is in the scope of ASC Topic 805. ASC
paragraph 825-10-25-11
1.003 A business in ASC Topic 805 focuses on an integrated set of activities and assets
capable of being conducted and managed for the purpose of providing a return. This
requires that the integrated set include inputs and processes applied to those inputs which,
together are or will be used to create outputs, but does not necessarily require that it
currently include outputs. See discussion of Identifying a Business Combination in
Section 2.
VARIABLE INTEREST ENTITIES
1.004 Under ASC Subtopic 810-10, Consolidation - Overall, the initial consolidation of a
variable interest entity (VIE) that is a business by its primary beneficiary is a business
combination and should be accounted for by the acquisition method.
1.005 Paragraph not used.
1.006 ASC Subtopic 810-10 requires an entity to determine whether it is the primary
beneficiary of a VIE at the time it becomes involved with the VIE, and to continuously
reassess whether changes in facts and circumstances result in a change in the
determination of whether the entity is the primary beneficiary of the VIE. When an entity
becomes the primary beneficiary of a VIE that is a business, even if the entity was
previously involved with the VIE but was not the primary beneficiary, a business
combination has occurred and must be accounted for by the acquisition method at that
date. See discussion of Variable Interest Entities in Section 4.
When a Variable Interest Entity and its Primary Beneficiary Are under Common
Control
1.007 Combinations between entities or businesses under common control are outside the
scope of ASC Subtopic 805-10. However, ASC Subtopic 810-10 provides guidance for
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1. Scope
situations in which an entity becomes the primary beneficiary of a VIE when the primary
beneficiary and the VIE are under common control. In these situations, the primary
beneficiary initially measures the assets, liabilities, and noncontrolling interests of the
VIE at amounts at which they are carried in the accounts of the reporting entity (i.e., the
ultimate parent) that controls the VIE (or would be carried if the reporting entity issued
financial statements prepared in conformity with generally accepted accounting
principles). ASC paragraph 810-10-30-1
MUTUAL ENTITIES
1.008 Combinations of mutual entities are in the scope of ASC Topic 805.
LEVERAGED BUYOUT TRANSACTIONS
1.009 Under ASC Topic 805, the acquirer will account for leveraged buyout transactions
resulting in a change in control by the acquisition method.
TRANSACTIONS OUTSIDE THE SCOPE OF ASC TOPIC 805
1.010 ASC Topic 805 does not apply to the formation of a joint venture, the acquisition
of an asset or a group of assets that does not constitute a business, a combination between
entities or businesses under common control, or a combination between not-for-profit
organizations or the acquisition of a for-profit business by a not-for-profit organization.
The Formation of a Joint Venture
1.011 The definition of a corporate joint venture in ASC Subtopic 323-10, Investments--
Equity Method and Joint Ventures - Overall, applies in assessing whether an entity is a
joint venture.
ASC Paragraph 323-10-20: Corporate Joint Venture
A corporation owned and operated by a small group of entities (the joint
venturers) as a separate and specific business or project for the mutual benefit of
the members of the group. A government may also be a member of the group. The
purpose of a corporate joint venture frequently is to share risks and rewards in
developing a new market, product or technology; to combine complementary
technological knowledge; or to pool resources in developing production or other
facilities. A corporate joint venture also usually provides an arrangement under
which each joint venturer may participate, directly or indirectly, in the overall
management of the joint venture. Joint venturers thus have an interest or
relationship other than as passive investors. An entity that is a subsidiary of one of
the joint venturers is not a corporate joint venture. The ownership of a corporate
joint venture seldom changes, and its stock is usually not traded publicly. A
noncontrolling interest held by public ownership, however, does not preclude a
corporation from being a corporate joint venture.
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1. Scope
Because none of the participants in the formation of a joint venture obtains control over
the entity, the formation of a joint venture does not meet the definition of a business
combination under ASC Topic 805. However, control is not the only defining
characteristic of a joint venture. In fact, ASC paragraph 805-10-S99-8 states that the SEC
staff will object to a conclusion that joint control is the only defining characteristic of a
joint venture. Rather, each of the characteristics in the definition should be met for an
entity to be a joint venture, including that the purpose of the entity is consistent with that
of a joint venture. ASC paragraph 805-10-S99-8 further indicates that in the stand-alone
financial statements of a venture, ASC Topic 805 should be applied to transactions where
businesses are contributed to a jointly controlled entity that does not meet the definition
of joint venture.
1.012 There have been questions in practice related to the accounting by the joint venture
for contributions received from the joint venture investors when not in the scope of ASC
Topic 805. With the exception of the AICPA Issues Paper Joint Venture Accounting
(7/17/79) and certain SEC guidance, there has been minimal authoritative guidance for
the accounting by the joint venture itself. Historical practice has been that a joint venture
generally measured contributions at the investor’s basis (i.e., carryover basis), unless
certain conditions were met (e.g., an investor’s cash contribution that remains in the joint
venture). However, based on the AICPA Issues Paper, nonpublic companies may adopt a
policy using either fair value or carryover basis.
1.012a At the 2009 AICPA National Conference on Current SEC and PCAOB
Developments, an SEC staff member acknowledged that the amendments to investor
accounting in ASU 2010-02, Accounting and Reporting for Decreases in Ownership of a
Subsidiary—a Scope Clarification, raised questions about the joint venture’s accounting
for contributions from the investors.1 While the SEC staff did not provide specific views
about how the changes to investor accounting under ASU 2010-02 might affect the
accounting by the joint venture, the SEC staff did acknowledge that there may be more
instances in which it would be appropriate for the joint venture to record the contributions
at fair value.
1.012b Based on informal discussions with the SEC staff, we understand that the SEC
staff would not object if a joint venture measured contributions at fair value when the
investors’ accounting is within the scope of ASC Subtopic 810-10 (see Chapter 7 of
KPMG Handbook, Consolidation). We believe this view is supported because a change-
in-control event has occurred and therefore the investors measure the contributed assets
(businesses) at fair value before contributing to the joint venture. Accordingly, the
investors’ basis is fair value to be carried over by the joint venture.
1.012c We understand that the SEC staff would object to a joint venture recognizing at
fair value contributions by investors that are outside the scope of the fair value provisions
in ASC Subtopic 810-10 (e.g., groups of assets that do not constitute businesses). In those
instances, companies should continue to follow the SEC staff’s historical practice for
joint ventures (investor’s carryover basis), unless certain conditions are met (e.g., an
investor’s cash contribution that remains in the joint venture). This is due to the fact that
the transfer of a subsidiary or group of assets that does not constitute a business in
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1. Scope
exchange for an interest in a joint venture is outside the scope of the fair value provisions
of ASC Subtopic 810-10 for an investor. Consequently, the rationale described above
(Paragraph 1.012b) for fair value treatment at the joint venture level would not apply for
such transactions. It is possible that a joint venture could have a mixed accounting model
with some of the contributed assets measured at fair value (i.e., contributed assets
constituting a business) and other contributed assets measured at the investor’s carryover
basis (i.e., the contributed assets do not constitute a business).
The Acquisition of an Asset or a Group of Assets That Do Not Constitute a
Business
1.013 If an acquired asset or an asset group (including liabilities assumed, if any) does
not constitute a business, the transaction is not a business combination. These
transactions would be accounted for as asset acquisitions. The Acquisition of Assets
Rather than a Business Subsections of ASC Subtopic 805-50 provide continuing
authoritative guidance with respect to the accounting for asset acquisitions. Asset
acquisitions are accounted for using a cost accumulation and allocation model rather than
the ASC Topic 805 model, which requires measurement of assets acquired and liabilities
assumed at fair value with limited exceptions. There may be significant differences in the
accounting for the acquisition of a group of assets versus a business. Examples of these
differences are provided in Table 2.3.
A Combination between Entities or Businesses under Common Control
1.014 Combinations between entities or businesses under common control involve
exchanges or movements of net assets or equity interests among entities under common
control, such that the same ultimate parent controls the entities both before and after the
exchange or movement. These transactions do not result in an acquirer outside the control
group obtaining control over the net assets or equity interests, but result in a shift of
ownership of the net assets or equity investments within the entities or businesses under
common control. Therefore, combinations between entities under common control do not
meet the definition of a business combination.
1.015 Transfers or exchanges of net assets or equity instruments between entities under
common control should be recorded at the carrying amount of the transferring entity at
the date of transfer. If the carrying amounts of the assets and liabilities transferred differ
from the historical cost of the ultimate parent of the entities under common control, e.g.,
because push-down accounting was not applied, then the financial statements of the
receiving entity should reflect the transferred assets and liabilities at the historical cost of
the ultimate parent of the entities under common control. The Transactions between
Entities Under Common Control Subsections of ASC Subtopic 805-50 provide
continuing authoritative guidance for transactions between entities under common
control. See Section 28, Combinations of Entities under Common Control, for additional
discussion.
1.016 If a transaction results in the acquisition of all, or part, of a noncontrolling interest
in a subsidiary (i.e., an increase in the ultimate parent’s controlling interest in a
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1. Scope
subsidiary), the acquisition of the noncontrolling interest is accounted for as an equity
transaction based on ASC Subtopic 810-10. If a common control transaction results in an
increase in the noncontrolling interest of a subsidiary (i.e., a disposition of a portion of
the ultimate parent’s interest in a subsidiary where the parent retains control after the
transaction), the transaction is also accounted for as an equity transaction based on ASC
Subtopic 810-10. No gain or loss is recognized in consolidated net income or
comprehensive income as a result of changes in the noncontrolling interest, unless a
change results in the loss of control by the ultimate parent.
A Combination between Not-for-Profit Organizations or the Acquisition of a For-
Profit Business by a Not-for-Profit Organization
1.017 ASC Subtopic 958-805, Not-for-Profit Entities – Business Combinations, provides
guidance on accounting by not-for-profit entities for a combination with one or more
other not-for-profit entities, businesses, or not-for-profit activities. Under ASC Subtopic
958-805, which includes guidance on whether a combination is a merger or an
acquisition, a not-for-profit entity applies the carryover method to account for a merger
and the acquisition method to account for an acquisition.
1.018 The implementation guidance in ASC paragraphs 958-805-55-1 through 55-8
provides indicators that not-for-profit entities should consider when determining whether
a combination is a merger or an acquisition. However, all of the facts and circumstances
of the combination should be considered in making this determination.
1.018a ASC paragraph 958-805-55-1 states that ceding control by the prior not-for-profit
entities to a new not-for-profit entity is the sole definitive criterion for identifying a
merger, and one entity obtaining control over the other is the sole definitive criterion for
an acquisition. If the participating entities in a combination retain shared control of the
new not-for-profit entity, they have not ceded control. To qualify as a new not-for-profit
entity, the newly established combined not-for-profit entity must have a newly formed
governing body and is often, but not required to be, a new legal entity. ASC paragraphs
958-805-55-3 through 55-7 include additional considerations for purposes of evaluating
whether a combination is a merger or an acquisition and focus on areas such as
governance, related control powers, and financial capacity. These considerations include:
• Assessing whether the governing bodies of the entities participating in the
combination ceded control and understanding the process leading up to the
combination and the formation of the combined entity. (ASC paragraph 958-
805-55-3)
• ASC paragraph 958-805-55-4 states that one entity dominating the
negotiations is an indicator of an acquisition, whereas a situation where no
one party dominates or is capable of dominating the negotiations and
process leading to the formation of the combined entity is an indicator of a
merger.
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1. Scope
• We believe that decisions made on a mutual basis, such as the transaction
timing, strategic plan, and operating plans associated with the transaction,
indicate a merger.
• ASC paragraph 958-805-55-6 states that if one entity appoints
significantly more of the governing board to the newly formed entity,
retains more of its key senior officials, bylaws, operating policies, and/or
practices, it may be more indicative of an acquisition than a merger.
• We believe other relevant characteristics to consider include board term
limits, voting rights, and future board composition. For example, the board
of the new entity usually includes board members from the previous
entities' governing bodies. If those board members' initial terms are long
and they can continue to be reappointed, this factor would indicate that the
same prior leadership is still intact, and therefore control is being shared
and has not been ceded.
• Alternatively, it may be reasonable to conclude that a combination is a
merger even if the new board includes some individuals who were
formerly members of the recently terminated legacy boards, if the new
entity implements term limits, supermajority voting requirements, or other
board member transition plans that meet the requirement of ceding
control.
• We believe consideration should be given to existing affiliate and joint
venture ownership governance. For example, if ultimate control of all
existing affiliates and joint ventures resides with the new entity (i.e., all
key operating and strategic decision will be controlled by the new entity's
board of directors), that would indicate a merger.
• Analyzing the financial strength and size of each of the participating entities.
(ASC paragraph 958-805-55-6)
• ASC paragraph 958-805-55-6 indicates that if one entity is financially
stronger and larger in size, that entity may be able to dominate the
negotiations and transaction, which would be more indicative of an
acquisition than a merger. To gauge the relative financial strength of the
participating entities, we believe one can look at the credit ratings of the
entities involved in the combination as part of the process. Financial
strength and size, however, is just an indicator and should not be the only
consideration in determining whether a combination is a merger or an
acquisition.
• We believe that if one of the participating entities is experiencing financial
difficulties and will depend on the other entity to provide back-office or
information technology support for a below-cost fee, it could be an
indicator of an acquisition.
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1. Scope
• To gauge the relative size of the participating entities, we believe one can
look at the participating entities' pre-combination total assets, total net
assets, operating income, and total revenues, among other factors.
• Understanding the contributions made by the participating entities to the
combination. (ASC paragraph 958-805-55-7)
• ASC paragraph 958-805-55-7 indicates that a merger generally is
accomplished by a newly formed entity assuming all of the assets and
liabilities of the participating entities without transferring cash or other
assets to those entities or any of their owners, members, sponsors, or other
designated beneficiaries. For example, in a merger, there are no:
• Financial inducements for the benefit of one party, such as built-in
capital or funding commitments;
• Guarantees, assumptions, or payoffs of the debt of either party by the
other as part of the transaction; or
• Commitments for guarantees or credit support on future debt for either
participating entity.
• ASC paragraph 958-805-55-7 also indicates that unlike the formation of a
joint venture arrangement in which the participating entities continue to
exist and usually hold a financial interest, the creators of the merged entity
cease to exist as autonomous entities and no one holds a financial interest
in the merged entity. The merged entity generally has a perpetual life
rather than a life that is limited by the period of the venture or that allows
for one or more of the participating entities to opt out of the venture or
other arrangement.
• We believe that one entity making significantly more contributions than
another may be indicative of an acquisition over a merger.
1.018b ASC paragraphs 958-805-55-9 through 55-31 provide illustrative examples for
assessing whether a combination is a merger, an acquisition, or is neither a merger nor an
acquisition.
1.018c All of the indicators and illustrative examples should be carefully considered
based on the actual facts and circumstances in determining whether the combination is a
merger or an acquisition. In accordance with ASC paragraph 958-805-55-2, the
participating not-for-profit entities must make a decision based on the preponderance of
the evidence about whether each of the governing bodies has ceded control to create a
new not-for-profit, whether one entity has acquired the other, or whether another form of
combination, such as the formation of a joint venture, has occurred.
Financial Assets and Financial Liabilities of a Collateralized Financing Entity
1.019 A collateralized financing entity (CFE) is an entity that holds financial assets such
as asset-backed securities and issues beneficial interests to investors. These beneficial
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1. Scope
interests are usually debt instruments that are considered financial liabilities under U.S.
GAAP. Because a CFE generally has little or no equity, it is typically a variable interest
entity (VIE) under U.S. GAAP and subject to the consolidation requirements that apply
to an entity not controlled through voting equity interests. Consequently, an entity may be
the primary beneficiary of, and therefore required to consolidate, a CFE if it has a
controlling financial interest in the CFE. Unlike the initial consolidation of a VIE that is a
business, which should be accounted for under the acquisition method, the consolidation
of the financial assets and financial liabilities of a VIE that is a CFE is excluded from the
scope of ASC Topic 805 and should not be accounted for under the acquisition method.
1 Joshua S. Forgione, Remarks before the 2009 AICPA National Conference on Current SEC and PCAOB
Developments, December 7, 2009, available at www.sec.gov.
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Section 2 - Identifying a Business
Combination
Detailed Contents
Definition of a Business Combination
Control
Control Defined
Control Does Not Exist if Minority Shareholders (or Other Interest Holders) Have
Substantive Participating Rights
Determination of Control Is a Point-In-Time Evaluation
Example 2.0: Acquisition of a Franchisee
Example 2.0a: Purchase of a Business That Was Subsequently Cancelled
Control Achieved Without Transferring Consideration
Transfer of Consideration Without Obtaining Control of a Business
Combinations Involving Variable Interest Entities
Multiple Transactions Accounted for as a Single Transaction
Example 2.0b: Accounting for Goodwill When Multiple Transactions That Cross
Reporting Periods Are Accounted for as a Single Business Combination
Definition of a Business
Table 2.2a: Other Areas Affected by the Definition of a Business
Table 2.3: Significant Difference in the Accounting for the Acquisition of a
Group of Assets Versus a Business
Inputs, Processes, and Outputs
Example 2.6: Determining What Is a Part of the Set - Multiple Transactions with
the Seller
Example 2.7: Determining What Is a Part of the Set - Contractual Arrangement
with a Third Party
Step 1 –Screening Test
Example 2.8a: Applying Step 1a
Example 2.8b: Applying Step 1b
Example 2.8bb: Applying Exception (a) in Step 1b
Table 2.4: Risk Factors and Examples to Consider When Identifying Similar
Assets
Example 2.8c: Applying Step 1c
Example 2.8cc: Acquisition of Owned and Leased Assets
Example 2.8d: Applying Step 1d
Example 2.8e: Applying Step 1e
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2. Identifying a Business Combination
Example 2.8f: Recognizing Certain Assets of a Medical Device Company as a
Single Asset for Financial Reporting Purposes
Example 2.9: Applying Step 1 When Goodwill Results from the Effects of
Deferred Tax Liabilities
Example 2.9a: Applying the Step 1 Threshold (Initial Screening) Test When a
Bargain Purchase Exists
Example 2.10: Acquisition of Loan Portfolio – Scenario 1
Example 2.11: Acquisition of Oil and Gas Properties – Scenario 1
Example 2.11a: Acquisition of Petroleum Storage Facilities
Example 2.11b: Acquisition of a Property Subject to a Tax Abatement
Step 2 – Evaluate Whether an Input and a Substantive Process Exist
Example 2.12: Acquisition of a Drug Candidate – Scenario 1
Example 2.13: Acquisition of Biotech – Scenario 1
Example 2.13a: Acquisition of Professional Service Employees
Example 2.13b: Intent to Restructure Workforce Post-Acquisition
Example 2.14: Acquisition of Real Estate – Scenario 2
Example 2.15: Acquisition of Loan Portfolio – Scenario 1 (continued)
Example 2.16: Acquisition of Loan Portfolio – Scenario 2
Example 2.17: Acquisition of Brands – Scenario 1
Example 2.18: Acquisition of Oil and Gas Properties – Scenario 2
Example 2.19: Acquisition of Properties That Are Simultaneously Leased to
Another Party
Applying the Definition of a Business to Financial Services Companies
Example 2.20: Acquisition of a Bank Branch
Example 2.21: Acquisition of an Asset Management Firm
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2. Identifying a Business Combination
DEFINITION OF A BUSINESS COMBINATION
ASC Master Glossary: Business Combination
A transaction or other event in which an acquirer obtains control of one or more
businesses. Transactions sometimes referred to as true mergers or mergers of
equals also are business combinations. See also Acquisition by a Not-for-Profit
Entity.
ASC Paragraph 805-10-25-1
An entity shall determine whether a transaction or other event is a business
combination by applying the definition in this Subtopic, which requires that the
assets acquired and liabilities assumed constitute a business. If the assets acquired
are not a business, the reporting entity shall account for the transaction or other
event as an asset acquisition...
2.000 Each transaction or event involving entities within the scope of ASC Topic 805,
Business Combinations (see discussion in Section 1), that falls within the definition of a
business combination is accounted for by applying the acquisition method.
2.001 The definition of a business combination includes all transactions or events in
which an entity obtains control of a business, regardless of whether the entity obtains
control through the transfer of consideration or without the transfer of consideration.
Fundamental to the FASB’s definition is its belief that all transactions or events in which
an entity acquires control over a business are economically similar, and that the definition
of a business combination should encompass all such transactions or events.
2.002 ASC paragraph 805-10-55-3 provides examples (not intended to be an exhaustive
listing) of ways a business combination may be structured for legal, taxation, or other
reasons:
(a) One or more businesses become subsidiaries of an acquirer or the net assets of
one or more businesses are legally merged into the acquirer.
(b) One combining entity transfers its net assets or its owners transfer their equity
interests to another combining entity or its owners.
(c) All of the combining entities transfer their net assets or the owners of those
entities transfer their equity interests to a newly formed entity (sometimes
referred to as a roll-up or put-together transaction).
(d) A group of former owners of one of the combining entities obtains control of
the combined entity.
2.003 The structure of a transaction or event does not affect the determination of whether
a business combination has occurred. Rather, the obtaining of control of one or more
businesses by an acquirer is determinative. The concepts of control and what constitutes a
business are discussed below. Identifying the accounting acquirer is discussed in Section
4.
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2. Identifying a Business Combination
CONTROL
CONTROL DEFINED
ASC Master Glossary: Control
The same as the meaning of controlling financial interest in [ASC] paragraph 810-
10-15-8.
2.004 ASC Subtopic 810-10 indicates that majority ownership is not always
determinative and that majority ownership would not constitute a controlling financial
interest if control does not rest with the majority owner. Conversely, an investor could
obtain control over a business in situations where the investor owns less than a majority
of the voting interest of an investee (e.g., in combinations achieved by contract alone).
More specifically, ASC paragraphs 810-10-15-8 and 810-10-15-8A state:
For legal entities other than limited partnerships, the usual condition for a
controlling financial interest is ownership of a majority voting interest, and,
therefore, as a general rule ownership by one reporting entity, directly or
indirectly, of more than 50 percent of the outstanding voting shares of another
entity is a condition pointing toward consolidation. The power to control may also
exist with a lesser percentage of ownership, for example, by contract, lease,
agreement with other stockholders, or by court decree.
Given the purpose and design of limited partnerships, kick-out rights through
voting interests are analogous to voting rights held by shareholders of a
corporation. For limited partnerships, the usual condition for a controlling
financial interest, as a general rule, is ownership by one limited partner, directly
or indirectly, of more than 50 percent of the limited partnership’s kick-out rights
through voting interests. The power to control also may exist with a lesser
percentage of ownership, for example, by contract, lease, agreement with
partners, or by court decree.
2.005 ASC paragraphs 805-10-55-10 through 55-15 provide guidance for identifying the
entity that obtains control (i.e., the acquirer) in a business combination if the guidance in
ASC Subtopic 810-10 does not clearly indicate which of the combining entities is the
acquirer. See discussion in Section 4, Identifying the Acquirer.
2.006 ASC Subtopic 810-10, Consolidation - Overall, provides guidance on the
consolidation of variable interest entities. See discussion of Variable Interest Entities
beginning at Paragraph 2.014.
CONTROL DOES NOT EXIST IF MINORITY SHAREHOLDERS (OR OTHER
INTEREST HOLDERS) HAVE SUBSTANTIVE PARTICIPATING RIGHTS
2.007 As noted in ASC paragraphs 810-10-15-8 and 810-10-15-8A, ownership of a
majority voting interest does not constitute a controlling financial interest if control does
not rest with the majority owner or, for limited partnerships, the limited partner with a
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2. Identifying a Business Combination
majority of kick-out rights through voting interests. For example, as discussed in ASC
paragraphs 810-10-25-1 through 25-14C and 55-1, a minority shareholder (or
shareholders) or another limited partner (or limited partners) may have substantive
participating rights such that the majority shareholder or the limited partner with a
majority of kick-out rights through voting interests is unable to exercise control over an
investee. See additional discussion about control in Chapter 5 of KPMG Handbook,
Consolidation.
2.008 – 2.010 Not used.
DETERMINATION OF CONTROL IS A POINT-IN-TIME EVALUATION
2.010a An entity can obtain control with the intention of relinquishing it in the future.
Control is a point-in-time evaluation, and a business combination occurs when an
acquirer obtains control of one or more businesses. Thus, when an entity obtains control
of a business, even if it is expected to be temporary, a business combination has occurred
and the transaction is within the scope of ASC Topic 805. There is no concept of
temporary control that allows for an exception from the scope of ASC Topic 805.
2.010b Careful consideration should be given to contractual terms that accompany
transactions with the intention of temporary control. Such terms may include substantive
participating rights, which may prevent control, or reacquisition rights granted to the
seller, which may be part of the consideration transferred in the business combination.
Example 2.0: Acquisition of a Franchisee
Franchisor operates a franchise with numerous stores owned by various franchisees.
The franchise agreement stipulates certain conditions that the franchisee must maintain
while owning and operating the franchise, including holding a business license to
operate in its state or territory.
Franchisee does not maintain its business license. Franchisee applies for a new license,
but regulatory approval and issuance is expected to take six months. Franchisee and
Franchisor agree that Franchisor will acquire and operate the store until the business
license is obtained. Control is intended to be temporary, and Franchisee holds a
reacquisition right to repurchase the store at a formulaic price at any time in the next
nine months, exercisable only after it obtains the business license. Franchisee will have
no substantive participating rights while the store is owned by Franchisor. The store
meets the definition of a business in ASC Topic 805.
Assessment
Franchisor concludes that the acquisition is a business combination because it has
obtained control of a store that meets the definition of a business. After the transaction,
Franchisee holds no rights to control the activities and decisions of the franchise during
the period that it is owned by Franchisor. Additionally, Franchisor has sole rights and
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2. Identifying a Business Combination
obligations to income or losses of the franchise during the period of ownership. The
fact that control is intended to be temporary, and the fact that Franchisee holds a
reacquisition right is not determinative in the analysis of control.
Franchisor should recognize the fair value of the reacquisition right (i.e., written call
option) as part of the consideration transferred under ASC Topic 805 and evaluate the
terms of the reacquisition right to determine whether it constitutes a derivative
instrument requiring subsequent measurement at fair value under ASC Topic 815.
Example 2.0a: Purchase of a Business That Was Subsequently Cancelled
ABC Corp. enters into a purchase agreement to acquire a private label widget
manufacturer (DEF Corp.) during April 20X0. Under the terms of the purchase
agreement, ABC will pay the seller of DEF Corp. (Seller) a total of $40,000,000,
consisting of $8,000,000 on the closing date (April 30, 20X0) and two installments of
$16,000,000 on August 31, 20X0 and February 28, 20X1 (deferred balance).
The purpose of the transaction is to create an exclusive business arrangement between
DEF and Seller, under which DEF will sell its widgets exclusively to Seller for a
period of 10 years. There is a limited guarantee agreement which limits ABC’s
exposure in potential losses of DEF to $2,500,000 until the final installment payment
occurs. There is also a share pledge agreement under which ABC does not have voting
rights in DEF until it pays the final installment, and the DEF shares are returned to
Seller if ABC does not pay the installments when due. Additionally, there is a shared
services agreement under which Seller provides management, accounting, human
resources, and information technology services to DEF.
Shortly after the closing date, ABC experiences turnover in several key executive
management positions, and during August 20X0, ABC notifies Seller that it no longer
intends to pay the $32,000,000 deferred balance. During December 20X0, ABC and
Seller finalize negotiations and enter into a sales cancellation agreement.
Assessment
ABC concludes that no business combination took place because it never obtained
control over DEF. ABC bases this conclusion on the fact that it did not obtain the
voting rights associated with the shares, nor did it have control over management and
human resource decisions, as these were outsourced to Seller under the shared services
agreement. ABC accounts for the initial payment of $8,000,000 as a deposit and
evaluates it for impairment.
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2. Identifying a Business Combination
CONTROL ACHIEVED WITHOUT TRANSFERRING CONSIDERATION
2.011 An entity can obtain control over another without transferring consideration. ASC
paragraph 805-10-25-11 identifies the following circumstances under which an acquirer
might obtain control over an acquiree without transferring consideration:
(a) The acquiree repurchases a sufficient number of its own shares for an existing
investor (the acquirer) to obtain control.
(b) Minority substantive participating rights lapse that previously kept the
acquirer from controlling an acquiree in which the acquirer held the majority
voting interest.
(c) The acquirer and acquiree agree to combine their businesses by contract alone.
The acquirer transfers no consideration in exchange for control of an acquiree
and holds no equity interests in the acquiree, either on the acquisition date or
previously.
2.012 A business combination occurs when an acquirer obtains control of one or more
businesses. Thus, when an entity obtains control of a business, even without the transfer
of consideration, a business combination has occurred and is within the scope of ASC
Topic 805. Therefore, the acquisition method applies to these transactions, which
requires, among other things, recognizing and measuring the assets acquired, the
liabilities assumed, and any noncontrolling interest in the acquiree. ASC Topic 805
provides special guidance for these types of transactions. Applying the acquisition
method to each of these types of transactions is discussed and illustrated beginning at
Paragraph 9.003.
2.013 Business combinations achieved by contract alone often result from the formation
of a variable interest entity that meets the definition of a business. If the variable interest
entity is a business, the primary beneficiary of the variable interest entity is always the
acquirer. See discussion below and the discussion of Variable Interest Entities beginning
at Paragraph 4.025.
TRANSFER OF CONSIDERATION WITHOUT OBTAINING CONTROL OF A
BUSINESS
2.013a In certain circumstances, an entity may transfer consideration before obtaining
control of a business. In this case a business combination has not occurred as the entity
has not obtained control of a business, and the entity should not apply the acquisition
method. Instead, the entity should recognize the consideration transferred as an asset (e.g.
a prepaid asset or deposit) given it meets the definition of an asset under Concepts
Statement 6. The entity should derecognize the asset and apply the acquisition method
when it obtains control of the business.
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2. Identifying a Business Combination
COMBINATIONS INVOLVING VARIABLE INTEREST ENTITIES
2.014 ASC Subtopic 810-10 clarifies the application of control to entities in which equity
investors or limited partners lack power, through voting rights or similar rights, the
obligation to absorb the expected losses or receive the expected residual returns of the
entity, or lack sufficient equity at risk for the entity to operate without additional
subordinated financial support from other parties. These entities are referred to as
variable interest entities, or VIEs. See KPMG Handbook, Consolidation for addition
guidance on VIEs.
2.015 ASC Topic 805 specifies that the acquirer of a VIE that is a business is the primary
beneficiary. Determining which party, if any, is the primary beneficiary of a VIE is made
based on ASC Subtopic 810-10. The initial consolidation of a VIE that is a business is a
business combination, and the primary beneficiary always is the acquirer. See discussion
of Variable Interest Entities beginning at Paragraph 4.025.
MULTIPLE TRANSACTIONS ACCOUNTED FOR AS A SINGLE
TRANSACTION
2.015a An entity may enter into multiple transactions to acquire a business. Examples
include:
• An entity initially purchases 30 percent of a business and then shortly
thereafter purchases an additional 25 percent to gain control.
• An entity negotiates the acquisition of a business in aggregate, but
consummates the acquisition by entering into separate legal agreements with
each business subsidiary.
• Assets and processes are acquired over time that do not meet the definition of
a business on an individual basis, but would constitute a business if evaluated
together.
2.015b We believe the following factors listed in ASC paragraph 810-10-40-6 (related to
deconsolidation) may be considered to determine whether multiple transactions should be
accounted for as a single transaction:
• They are entered into at the same time or in contemplation of one another.
• They form a single transaction designed to achieve an overall commercial
effect.
• The occurrence of one arrangement is dependent on the occurrence of at least
one other arrangement.
• One arrangement considered on its own is not economically justified, but they
are economically justified when considered together. An example is when one
disposal is priced below market, compensated for by a subsequent disposal
priced above market.
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2. Identifying a Business Combination
2.015c If an entity determines that each transaction should be accounted for separately,
assets acquired and liabilities assumed would be evaluated and accounted for separately
in accordance with applicable GAAP. Alternatively, if an entity determines that multiple
transactions should be accounted for as a single transaction, those transactions would be
evaluated and accounted on a combined basis in accordance with applicable GAAP.
Example 2.0b: Accounting for Goodwill When Multiple Transactions That
Cross Reporting Periods Are Accounted for as a Single Business
Combination
On October 15, 20X1, ABC Corp. enters into a purchase agreement to acquire DEF
Corp.’s fleet of merchant ships in two separate transactions, each representing the
acquisition of a business. ABC will transfer consideration of $210,000,000 to obtain
control of a portion of the fleet in transaction 1 on December 15, 20X1 and will transfer
consideration of $210,000,000 to obtain control of the remainder of the fleet in
transaction 2 on February 28, 20X2. ABC determines the two transactions should be
accounted for as a single business combination, as they are in contemplation of one
another and form a single transaction designed to achieve an overall commercial effect.
ABC obtains a valuation of the net assets acquired for both transactions.
Transaction 1 Transaction 2
Total
Consideration paid
$210,000,000
$210,000,000
$420,000,000
Fair value of net assets acquired $220,000,000
$180,000,000
$400,000,000
(Bargain purchase) / goodwill
$(10,000,000)
$30,000,000
$20,000,000
Assessment
As these two transactions are accounted for as a single business combination, ABC
determines that it should not recognize the bargain purchase amount from transaction 1.
We believe ABC should make an accounting policy election to either (1) record a
purchase price payable of $10,000,000 as of December 15, 20X1 and recognize goodwill
of $20,000,000 once it completes transaction 2 (during 20X2), or (2) recognize a pro rata
allocation of goodwill of $11,000,000(1) and a purchase price payable of $21,000,000 once
it completes transaction 1 (during 20X1) and recognize the remaining goodwill of
$9,000,000(2) once it completes transaction 2 (during 20X2).
(1) (220,000,000 / 400,000,000) × 20,000,000 = $11,000,000
(2) (180,000,000 / 400,000,000) × 20,000,000 = $9,000,000
2.016 – 2.024 Paragraphs not used
Table 2.1 – 2.2 Not used.
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2. Identifying a Business Combination
Examples 2.1 – 2.5: Not used.
DEFINITION OF A BUSINESS
2.025 Paragraph not used.
Table 2.2 Not used.
2.026 The evaluation of whether an acquired set of assets and activities (set) qualifies as a
business may have significant accounting implications beyond accounting for
acquisitions under ASC Topic 805. The definition of a business affects the accounting in
other areas of US GAAP including, but not limited to, the following:
Table 2.2a: Other Areas Affected by the Definition of a Business
Topic
Affected area
Goodwill
Impairment
Testing
Discontinued
Operations
A component of an operating segment is a
reporting unit if the component is a business
for which discrete financial information is
available and segment management regularly
reviews the operating results of that
component.
A business that meets the held for sale criteria
at the acquisition date is a discontinued
operation. If the one year criterion to be
classified as held for sale is met at the
acquisition date, a business is a discontinued
operation at the acquisition date if the other
held for sale criteria are probable of being met
within a short period following the acquisition
(usually within three months).
Paragraph
ASC paragraph
350-20-35-34
ASC paragraph
205-20-45-1D
Derecognition The deconsolidation and derecognition
guidance in ASC Topic 810 applies to
businesses. Businesses are excluded from the
derecognition guidance in ASC Subtopic 610-
20. See Chapter 7 of KPMG Handbook,
Consolidation for additional guidance on the
derecognition of assets and businesses.
ASC paragraphs
810-10-40-3A,
610-20-15-4, 360-
10-40-3B
Consolidations
If an entity meets the definition of a business,
it is scoped out of the VIE guidance in ASC
Topic 810 unless certain conditions exist.
ASC paragraph
810-10-15-17(d)
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2. Identifying a Business Combination
Consolidation
of a VIE that is
Not a Business
In the initial consolidation of a VIE that is not
a business, the primary beneficiary measures
and recognized the assets (except for goodwill)
and liabilities of the VIE in accordance with
the guidance on business combinations in ASC
sections 805-20-25 and 805-20-30. A gain or
loss is recognized.
ASC paragraphs
810-10-30-3 and
810-10-30-4
Spinoffs and
Nonreciprocal
Transfers
A spinoff or nonreciprocal transfer of a
business is recorded based on the carrying
value of the subsidiary (after reduction, if
appropriate, for an indicated impairment of
value).
ASC paragraphs
505-60-25-2, 845-
10-30-10
Gain or Loss
on Disposal
When a business is disposed of, goodwill
associated with that business shall be included
in the carrying amount of the business to
determine a gain or loss on disposal.
ASC paragraphs
350-20-40-2, 350-
20-40-9, 360-10-
35-39
Intangible
Asset
Impairment
Testing
The unit of accounting to test indefinite-lived
intangible assets for impairment cannot
represent a group of indefinite-lived intangible
assets that collectively are a business.
ASC paragraph
350-30-35-26
Eligibility for
cash flow
hedging
A business combination cannot be designated
as the hedged item in a cash flow hedge.
However, the guidance does not preclude a
forecasted asset acquisition from being
designated as the hedged item in a cash flow
hedge, assuming all other criteria are met.
ASC paragraph
815-20-25-15(g)
2.026a For a transaction or event to be a business combination, the set that the acquirer
has obtained control over must constitute a business. This is an important determination,
given the different accounting models for the acquisition of a group of assets versus a
business. Business combinations are accounted for using the ASC Topic 805 acquisition
method that requires measurement of assets and liabilities at fair value with limited
exceptions. Acquisitions of assets are accounted for using the cost accumulation and
allocation model. Examples of these differences are provided in Table 2.3.
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2. Identifying a Business Combination
Table 2.3: Significant Difference in the Accounting for the Acquisition of
a Group of Assets Versus a Business
Initial
Measurement
Asset Acquisition
Business Combination
The acquirer measures the assets
acquired based on their cost, which
is generally allocated to the assets on
a relative fair value basis.
The acquirer measures
identifiable assets and
liabilities generally at fair
value.
Direct
Acquisition-
Related Costs
The acquirer includes direct
acquisition-related costs in the cost
of the acquired assets.
The acquirer expenses direct
acquisition-related costs as
incurred.
Contingent
Consideration
If the arrangement is a derivative,
the acquirer initially measures
contingent consideration at fair
value with changes in fair value
reported currently in earnings.
Otherwise, the acquirer generally
recognizes contingent consideration
when it is probable and estimable.
Subsequent changes are generally
recorded as adjustments to the
carrying amount of the assets.
The acquirer recognizes
contingent consideration at
the acquisition date and
measures it at fair value.
Subsequent changes to the
fair value of liability-
classified contingent
consideration are reported
currently in earnings.
Settlement of
Preexisting
Relationships
There is no explicit guidance. We
believe acquirers should apply ASC
Topic 805 by analogy.
The acquirer recognizes a
gain or loss for the effective
settlement of a preexisting
relationship. The acquirer
measures the gain or loss
either:
(1) for a noncontractual
relationship, at fair value,
or
(2) for a contractual
relationship, at the lesser
of:
(a) the amount by
which the contract
is favorable or
unfavorable to the
acquirer, or
(b) the amount of
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2. Identifying a Business Combination
Measurement
Period
No concept of a measurement period
exists in an asset acquisition. The
acquirer must finalize all valuations
of assets acquired and liabilities
assumed before the next reporting
date.
Intangible
Assets
Intangible assets are recognized if
they meet the recognition criteria in
FASB Concepts Statement No.5,
Recognition and Measurement in
Financial Statements of Business
Enterprises, which is a lower
recognition threshold than the
criteria for intangible assets acquired
in a business combination.
In-process
Research and
Development
(IPR&D)
The portion of the purchase price
allocated to IPR&D at the
acquisition date is expensed
immediately unless it has an
alternative future use.
stated settlement
provisions in the
contract available
to the party to
whom the
contract is
unfavorable.
The acquirer may record
provisional amounts for the
assets acquired and liabilities
assumed and adjust them
during the measurement
period, which ends the earlier
of (1) one year from the
acquisition date, and (2)
when the acquirer has
obtained all relevant
information about facts that
existed at the acquisition date
or learns that more
information is not obtainable.
Intangible assets are
recognized at fair value if
they meet the contractual-
legal criterion or the
separability criterion.
Private companies and not-
for-profit entities may elect
an accounting policy to
subsume into goodwill non-
compete agreements and
customer-related intangibles
that cannot be sold or
licensed separately from
other assets of the business.
IPR&D is recognized and
accounted for as an
indefinite-lived intangible
asset until the acquirer
completes or abandons the
project.
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2. Identifying a Business Combination
Assembled
Workforce
Assembled workforce is recognized
as an intangible asset.
Reacquired
Rights
Acquired
Contingencies
There is no explicit guidance. The
acquirer may determine the
measurement basis of reacquired
rights either (1) using a
measurement based solely on the
remaining contractual terms (by
analogy to ASC Topic 805) or (2)
based on fair value.
Acquired contingencies are
accounted for under ASC Topic 450,
Contingencies. Acquired loss
contingencies are recognized if they
are both probable and reasonably
estimable. Gain contingencies are
not recognized until realized.
Indemnification
Assets
There is no explicit guidance.
Acquirers sometimes apply ASC
Topic 805 by analogy.
Goodwill
Goodwill is not recognized.
Generally, the acquirer allocates any
excess cost over the fair value of the
net assets acquired on a relative fair
value basis only to certain
nonfinancial assets acquired.
Assembled workforce is
recognized as a part of
goodwill.
The acquirer measures
reacquired rights based solely
on the remaining contractual
terms.
Acquired contingencies are
recognized and measured at
fair value if determinable at
the acquisition date or during
the measurement period.
Otherwise, they are
accounted for in a manner
consistent with ASC Topic
450.
The acquirer is required to
develop a systematic and
rational approach to
subsequent measurement,
depending on the nature of
the contingency.
The acquirer records an
indemnification asset at the
same time and on the same
basis as the indemnified item,
subject to any contractual
limitations and collectibility.
Any excess consideration
transferred over the fair value
of the net assets acquired is
goodwill and is recognized as
a separate asset.
Bargain
Purchase
Amount
Similar to goodwill, the acquirer
should allocate a bargain purchase
amount only to certain nonfinancial
assets on a relative fair value basis.
The acquirer recognizes a
bargain purchase gain
immediately in earnings.
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Deferred Taxes Because neither goodwill nor a
bargain purchase gain are
recognized, if the cost differs from
the tax bases of the assets acquired
and liabilities assumed, the
simultaneous equations method is
used to calculate the deferred tax
assets and liabilities and the
resulting adjustments to the related
assets’ and liabilities’ carrying
amounts. (See KPMG Handbook,
Accounting for Income Taxes
Section 10 - Other Considerations)
2. Identifying a Business Combination
Recognizing deferred tax
assets and liabilities results in
increases or decreases to
goodwill or a bargain
purchase gain. (See KPMG
Handbook Accounting for
Income Taxes Section 6 - The
Tax Effects of Business
Combinations)
2.026b For additional guidance on accounting for asset acquisitions, see KPMG
Handbook, Asset acquisitions.
INPUTS, PROCESSES, AND OUTPUTS
ASC paragraph 805-10-55-3A
A business is an integrated set of activities and assets that is capable of being
conducted and managed for the purpose of providing a return in the form of
dividends, lower costs, or other economic benefits directly to investors or other
owners, members, or participants. To be considered a business, an integrated set
must meet the requirements in [ASC] paragraphs 805-10-55-4 through 55-6 and
805-10-55-8 through 55-9.
ASC paragraph 805-10-55-4
A business consists of inputs and processes applied to those inputs that have the
ability to contribute to the creation of outputs. Although businesses usually have
outputs, outputs are not required for an integrated set to qualify as a business. The
three elements of a business are defined as follows:
(a) Input: Any economic resource that creates, or has the ability to contribute to
the creation of, outputs when one or more processes are applied to it.
Examples include long-lived assets (including intangible assets or rights to use
long-lived assets), intellectual property, the ability to obtain access to
necessary materials or rights, and employees.
(b) Process: Any system, standard, protocol, convention, or rule that when
applied to an input or inputs, creates or has the ability to contribute to the
creation of outputs. Examples include strategic management processes,
operational processes, and resource management processes. These processes
typically are documented, but the intellectual capacity of an organized
workforce having the necessary skills and experience following rules and
conventions may provide the necessary processes that are capable of being
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2. Identifying a Business Combination
applied to inputs to create outputs. Accounting, billing, payroll, and other
administrative systems typically are not processes used to create outputs.
(c) Output: The result of inputs and processes applied to those inputs that provide
goods or services to customers, investment income (such as dividends or
interest), or other revenues.
ASC paragraph 805-10-55-5
To be capable of being conducted and managed for the purposes described in
[ASC] paragraph 805-10-55-3A, an integrated set of activities and assets requires
two essential elements – inputs and processes applied to those inputs. A business
need not include all of the inputs or processes that the seller used in operating that
business. However, to be considered a business, the set must include at a
minimum, an input and a substantive process that together significantly contribute
to the ability to create output. [ASC] paragraphs 805-10-55-5A through 55-5C
provide a practical screen to determine when a set would not be considered a
business. If the screen is not met, further assessment is necessary to determine
whether the set is a business. [ASC] paragraphs 805-10-55-5D through 55-6 and
805-10-55-8 through 55-9 provide a framework to assist an entity in evaluating
whether the set includes both an input and a substantive process.
ASC paragraph 805-10-55-6
The nature of the elements of a business varies by industry and by the structure of
an entity’s operations (activities), including the entity’s stage of development.
Established businesses often have many different types of inputs, processes, and
outputs, whereas new businesses often have few inputs and processes and
sometimes only a single output (product). Nearly all businesses also have
liabilities, but a business need not have liabilities. In addition, some transferred
sets of assets and activities that are not a business may have liabilities.
2.027 The three elements of a business are inputs, processes, and outputs. While a
business typically has outputs, they are not required for a set to qualify as a business.
2.028 Inputs are resources that contribute to the creation of outputs when processes are
applied to the inputs. Generally, inputs are the assets in the set and include long-lived
tangible assets (e.g., real estate and equipment), intangible assets (e.g., intellectual
property, customer lists, trade names, patents, and recipes), materials, contracts that
provide the ability to obtain access to necessary materials or rights (e.g., distribution
rights, mineral interests, broadcast rights, supply contracts, and some service contracts),
and employees.
2.029 Processes are systems, standards, protocols, conventions, and rules that, when
applied to inputs, create or have the ability to contribute to the creation of outputs.
Processes typically include:
• Strategic management processes (e.g., the overall vision and direction of the
set that contribute to the creation of outputs and obtaining customers),
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2. Identifying a Business Combination
• Operational processes (e.g., the fulfillment, production, development, or
customer acquisition processes that contribute to creating outputs), and
• Resource management processes (e.g., processes involved in deploying
resources such as raw materials and employees to produce outputs).
Accounting, billing, payroll, and other administrative systems are typically not processes
used to create outputs in most industries.
2.030 An entity could acquire a process even if it is not documented. While employees
are an input, when they form an organized workforce, the capacity (e.g., knowledge,
skills, or experience) of that workforce to perform a process is acquired even if the
process is not documented. In other words, the workforce itself is an input but the
knowledge of the activities the workforce performs can be a process. However, as noted
in Paragraph 2.073, if the acquired set includes a workforce, other inputs must also be
present to conclude that the set is a business.
2.031 Outputs are the result of processes applied to inputs that provide goods or services
to customers, investment income (such as dividends or interest), or other revenues. In
general, outputs give rise to the revenue of the set. As discussed in paragraph BC59 of the
Basis for Conclusions of ASU 2017-01, Clarifying the Definition of a Business, the
FASB decided to align the definition of outputs with how that term is used in ASC Topic
606, Revenue from Contracts with Customers. However, a set does not need to have
contracts in the scope of ASC Topic 606 to have outputs because the definition includes
investment income and other revenues. For example, a set could generate outputs as a
result of leasing property in the scope of ASC Topic 840, Leases, or ASC Topic 842,
Leases, once adopted.
2.032 An integrated set does not need to include all of the inputs and processes that the
seller used in operating that set. For example, a set could qualify as a business if it is a
division, product line, or subsidiary of another entity. However, a set is a business only if
it has, at a minimum, an input and a substantive process that together significantly
contribute to the ability to create outputs. The evaluation requires an entity to consider
the substance of what was acquired regardless of whether the missing elements (e.g.,
missing inputs and processes) could be replaced by a market participant.
2.033 ASC Topic 805 includes two steps to determine if the minimum requirements to be
a business are met. Step 1 is a screening test that, if met, results in the conclusion that the
set is not a business. If Step 1 is not met, the entity evaluates whether the set includes an
input and a substantive process (Step 2). However, before performing these steps an
entity needs to identify the inputs, processes, and outputs included in the set.
Determining What Is a Part of the Set
2.034 In most cases, evaluating what is a part of the set will not be difficult, because the
items included in the set will be explicitly identified in the contract between the acquirer
and the seller. However, in other situations this analysis may not be straightforward and
significant judgment will be required.
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2. Identifying a Business Combination
Employees
2.035 In some transactions, the acquirer will not acquire a legal entity of the seller (for
tax or legal purposes this is often referred to as an asset acquisition instead of a stock
acquisition). For the acquirer to acquire employees of the seller, the employees are
terminated by the seller and hired by the acquirer. We believe the employees would be a
part of the acquired set and the form of the transaction would not be relevant in these
circumstances. However, all facts and circumstances need to be considered in
determining whether employees are part of the acquired set.
Multiple Transactions with the Acquirer and Seller
2.036 When an entity enters into multiple transactions at or near the same time with the
same counterparty to acquire assets or activities, it evaluates whether the substance is a
single transaction or multiple transactions. Entities should consider the factors in
Paragraph 2.015b to determine whether multiple transactions should be accounted for as
a single transaction.
2.037 In addition to the factors in Paragraph 2.015b, the guidance in ASC paragraphs
805-10-25-20 through 25-22 and 55-18 may be helpful in identifying whether a separate
contract entered into between the acquirer and seller to provide future goods or services
should be included in the set. That guidance indicates that some arrangements should be
accounted for separately as a settlement of a pre-existing relationship, a transaction that
compensates employees or former owners of the acquiree for future services, or a
transaction that reimburses the acquiree or its former owners for paying the acquirer’s
acquisition-related costs.
2.038 When re-deliberating ASU 2017-01, the FASB observed that many entities used
the guidance in ASC paragraphs 805-10-25-20 to 25-22 and 55-18 to determine whether
contractual arrangements were a part of the set; and in paragraph BC49 of the Basis for
Conclusions of ASU 2017-01, the FASB noted that entities should continue to use
judgment. As a result, that guidance remains relevant for determining whether contracts
between the acquirer and seller for future goods or services are a part of the acquired set
(see Section 11 for further details on this guidance).
2.038a Other indicators that a contract that compensates the seller for future goods or
services is not a part of the acquired set include when the future goods or services
provided by the seller are:
• Readily available in the marketplace; and
• An output of the seller's ordinary activities.
2.039 In addition, because the definition of a business is also relevant to the scope of
derecognition guidance (i.e., ASC Topic 810 and ASC Subtopic 610-20), we believe it is
also relevant to understand whether the seller disposed of an input or process. For
example, if a contract between the acquirer and seller does not involve the seller
transferring inputs or processes (e.g., it is a revenue contract from the perspective of the
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2. Identifying a Business Combination
seller), then that transaction is not considered a disposal of an input or process by the
seller, nor the acquisition of an input or process by the acquirer.
Example 2.6: Determining What Is a Part of the Set - Multiple Transactions
with the Seller
Entity A enters into a contract to sell a building to Entity B. At the same time, Entity A
and Entity B enter into a contract whereby Entity A will provide property management
services and Entity B will compensate Entity A for those services. The services are:
• Readily available in the marketplace; and
• A part of Entity A's ordinary activities.
Entity B evaluates whether the property management contract is a part of the set.
Consistent with the guidance in ASC paragraph 805-10-55-21, because the transaction
compensates the former owners for future services, the transaction would be considered
separate from the set. That is because acquirer is compensating the seller for future
property management services and the services are
• Readily available in the marketplace; and
• A part of the seller's ordinary activities.
Furthermore, in the property management contract, Entity A does not dispose of an input
or process.
As a result, Entity B concludes that the property management contract is not a part of the
acquired set.
Contractual Arrangements
2.040 A contract that is separately negotiated and entered into with an independent third
party by the acquirer is typically not a part of the set even if it was entered into at or near
the same time or relates directly to the acquirer's operation of the set. However, when the
seller and third party previously had a contractual relationship that transfers to the
acquirer the determination may not be as clear.
2.041 When evaluating whether a third party contract is a part of the set, the objective is
to determine if the acquirer and third party entered into a separately negotiated contract or
if the seller transferred the contract to the acquirer. In many cases, this will be a legal
distinction because a contract is either acquired through a legal entity or assigned by the
seller to the acquirer. However, entities should also evaluate the substance of the
arrangement when the acquirer and third party enter into a contract directly.
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2.041a To make this evaluation, entities should consider the following factors (not
exhaustive):
2. Identifying a Business Combination
• Whether the acquirer and third party entered into substantive
negotiations to continue the relationship. If the contract between the
acquirer and third party was the result of a bona fide negotiation, it may
indicate the contract is not a part of the set. In contrast, if the contract was not
the result of a bona fide negotiation, it may indicate the contract is a part of
the set.
• Whether it is feasible to change vendors. If changing vendors is not feasible
(even if available in the marketplace) because of a significant cost of changing
or disruption caused by the change, it might indicate that the negotiations
between the acquirer and third party are not substantive and the contract is a
part of the set. In contrast, the fact that it is convenient to maintain the same
vendor would not necessarily indicate the change was not feasible.
• Whether the goods or services are readily available in the marketplace. If
the services are unique or scarce such that the acquirer would not be able to
obtain the goods or services elsewhere, it might indicate that the seller
transferred the contractual relationship to the acquirer. If the goods or services
can be obtained in the marketplace, it might indicate that the contract is a
separately negotiated contract and not a part of the set.
• Whether the transaction can be closed without the contract transferring.
For example, if the contract between the acquirer and seller includes a
contingency that requires the contract between the acquirer and a third party to
be entered into, it would indicate the contract is a part of the set.
Example 2.7: Determining What Is a Part of the Set - Contractual
Arrangement with a Third Party
Entity A owns a hotel property and has an at-market in-place contract with Manager X to
manage that property. Entity B acquires the hotel from Entity A. Consider the following
scenarios:
Scenario 1
The contract between Entity A and Manager X has a change-in-control provision that
automatically terminates the contract on sale of the property. Entity B and Manager X
must enter into a new contract and neither party is required to continue the relationship.
Entity B and Manager X enter into a new contract with substantially similar terms.
The contract is not a part of the set because Entity B and Manager X had substantive
negotiations to enter into the new contract, the services are readily available in the
marketplace, the entity could reasonably replace the vendor with another party without a
significant disruption in operations and the consummation of the transaction was not
dependent upon entering into the new agreement.
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2. Identifying a Business Combination
Scenario 2
The contract between Entity A and Manager X does not terminate on sale of the property
and Entity A can assign the contract to other parties. Entity A assigns the management
contract to Entity B as a part of the transaction.
The contract is a part of the set. The contract transferred from Entity A to Entity B. While
the services are readily available in the marketplace, there were no substantive
negotiations between Entity B and Manager X.
Scenario 3
The contract between Entity A and Manager X does not terminate on sale of the property
and is assignable to other parties. At Entity B's request, Entity A terminates the contract
with Manager X before the close of the transaction. Entity B and Manager X enter into a
new contract with terms that are substantially the same as the contract between Entity A
and Manager X; however, the transaction could not close until Entity B and Manager X
had a new contract in place.
The contract is a part of the set. In substance, the contract transferred from Entity A to
Entity B. While Entity B and Manager X entered into a new contract, it was not a result
of a separate negotiation but rather the transaction was dependent on Entity B and
Manager X entering into the same contract. Furthermore, Entity A and Manager X only
terminated the contract to help facilitate the transaction closing.
STEP 1 –SCREENING TEST
ASC paragraph 805-10-55-5A
If substantially all of the fair value of the gross assets acquired is concentrated in
a single identifiable asset or group of similar identifiable assets, the set is not
considered a business. Gross assets acquired should exclude cash and cash
equivalents, deferred tax assets, and goodwill resulting from the effects of
deferred tax liabilities. However, the gross assets acquired should include any
consideration transferred (plus the fair value of any noncontrolling interest and
previously held interest, if any) in excess of the fair value of net identifiable assets
acquired.
ASC paragraph 805-10-55-5B
A single identifiable asset includes any individual asset or group of assets that
could be recognized and measured as a single identifiable asset in a business
combination. However, for purposes of this evaluation, the following should be
considered a single asset:
(a) A tangible asset that is attached to and cannot be physically removed and used
separately from another tangible asset (or an intangible asset representing the
right to use a tangible asset) without incurring significant cost or significant
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2. Identifying a Business Combination
diminution in utility or fair value to either asset (for example, land and
building)
(b) In-place lease intangibles, including favorable and unfavorable intangible
assets or liabilities, and the related leased assets.
ASC paragraph 805-10-55-5C
A group of similar assets includes multiple assets identified in accordance with
[ASC] paragraph 805-10-55-5B. When evaluating whether assets are similar, an
entity should consider the nature of each single identifiable asset and the risks
associated with managing and creating outputs from the assets (that is, the risk
characteristics). However, the following should not be considered similar assets:
(a) A tangible asset and an intangible asset
(b) Identifiable intangible assets in different major intangible asset classes (for
example, customer-related intangibles, trademarks, and in-process research
and development)
(c) A financial asset and a nonfinancial asset
(d) Different major classes of financial assets (for example, accounts receivable
and marketable securities)
(e) Different major classes of tangible assets (for example, inventory,
manufacturing equipment, and automobiles)
(f) Identifiable assets within the same major asset class that have significantly
different risk characteristics.
2.042 Step 1 is an initial screen to determine when a set is not a business. Step 1 requires
that when substantially all of the fair value of the gross assets acquired is concentrated in
a single identifiable asset or a group of similar identifiable assets, the set is not a
business. However, if Step 1 is not met, the entity will still need to evaluate Step 2 to
determine if the set is a business. While Step 1 is required, an entity could choose to go
directly to Step 2 if it concludes under Step 2 that the set is not a business. That is
because Step 1 could not contradict that conclusion. However, an entity will need to
appropriately evaluate Step 1 before concluding that a set is a business, because Step 1 is
determinative that a set is not a business regardless of an entity's interpretation of Step 2.
2.043 There may be circumstances when Step 1 could be completed solely on a
qualitative basis. Paragraph BC19 in the Basis for Conclusions of ASU 2017-01 states:
The assessment could be qualitative if, for example, an entity concludes that all of
the fair value will be assigned to one element of the acquisition. For example, if
the acquisition includes a license for a drug candidate and an at-market contract
and the entity concludes that the at-market contract has at the date of assessment
little or no fair value assigned to it or the fair value of a single identifiable asset or
group of similar identifiable assets is so significant that it is very clear that the
threshold will be met, the entity may conclude that the threshold has been met. If
there are multiple assets that the entity concludes will have more than an
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2. Identifying a Business Combination
insignificant value assigned, the entity may be able to qualitatively conclude that
there is clearly significant value in assets that are not similar and that the
threshold is not met and go on to the rest of the framework. However, an entity
must determine the fair value of each asset to allocate the consideration to assets
recognized in both an asset acquisition and a business combination…if the set is
not a business, an entity could choose to document its conclusion in the most cost-
effective manner depending on its situation.
We would expect an entity to document its qualitative analysis and its considerations to
conclude the screening test is met without a quantitative analysis.
The following flowchart illustrates the steps that may be useful when applying Step 1:
Step 1a: Determine all identifiable assets in the set
2.044 In Step 1a, an entity would determine all identifiable assets in the set. Paragraph
BC24 in the Basis for Conclusions of ASU 2017-01 states, "For ease of application, the
Board decided that an entity should use the same unit of account when assessing the
threshold that it would use for identifying assets recognized in a business combination
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2. Identifying a Business Combination
even if it results in some tangible assets and intangible assets being combined into a
single asset."
2.044a As a result, the starting point is to determine what assets would be recognized
under ASC Topic 805 if the set were considered a business rather than a group of assets.
2.045 For example, in a business combination an entity would recognize and measure an
in-process research and development (IPR&D) asset, but it typically would not recognize
IPR&D as an asset in an asset acquisition (see Question 4.2.20 in KPMG Handbook,
Asset acquisitions). Because the unit of account is the same as in a business combination,
a single IPR&D asset would be considered a single identifiable asset for purposes of
applying Step 1.
2.046 In contrast, an assembled workforce (or goodwill) is not an identifiable asset that
could be recognized in a business combination, but an assembled workforce intangible
asset could be recognized in an asset acquisition. Because the unit of account is the same
as in a business combination, an assembled workforce intangible asset would not be
considered a single identifiable asset for purposes of applying Step 1.
2.047 A single identifiable asset could also include certain complementary intangible
assets that are recognized and measured as a single asset in a business combination. For
example, ASC paragraph 805-20-55-18 states, "The terms brand and brand name, often
used as synonyms for trademarks and other marks, are general marketing terms that
typically refer to a group of complementary assets such as a trademark (or service mark)
and its related trade name, formulas, recipes, and technological expertise. This Subtopic
does not preclude an entity from recognizing, as a single asset separately from goodwill,
a group of complementary intangible assets commonly referred to as a brand if the assets
that make up that group have similar useful lives."
2.047a Similarly, some tangible assets and intangible assets (e.g., a nuclear power plant
and a license to operate it in ASC paragraph 805-20-55-2(b)) that are combined for
financial reporting purposes in a business combination would also be considered a single
identifiable asset for purposes of Step 1.
Example 2.8a: Applying Step 1a
Entity X acquires five separate apartment complexes. Each complex includes land,
building, property improvements, and at-market in-place tenant leases. Entity X first
determines the identifiable assets that could be recognized separately in a business
combination.
The land, building, property improvements, and in-place leases would be recorded as
separately identifiable tangible and intangible assets. Entity X also identifies an
intangible asset for the trade name associated with the apartment complexes.
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2. Identifying a Business Combination
As a result, the identifiable assets in the set include five parcels of land, five buildings,
various property improvements, the in-place lease intangible assets at each complex, and
the trade name intangible asset.
Step 1b: Combine any identifiable assets that meet exceptions in ASC paragraph
805-10-55-5B
2.048 ASC paragraph 805-10-55-5B provides two exceptions to the general rule
discussed in Step 1a. These exceptions require an entity to combine assets that would be
considered separately identifiable in a business combination as a single asset only for
purposes of applying Step 1.
2.048a Those exceptions are to consider as a single identifiable asset:
(1) A tangible asset that is attached to and cannot be physically removed and used
separately from another tangible asset (or an intangible asset representing the right to
use a tangible asset) without incurring significant cost or significant diminution in
utility or fair value to either asset (e.g., land and building); and
(2) In-place lease intangibles, including favorable and unfavorable intangible assets or
liabilities, and the related leased assets.
2.048b While identifiable assets that meet these exceptions are combined as a part of
Step 1b, they generally would be recorded separately regardless of whether the set is a
group of assets or a business. For example, a building and an in-place lease should be
measured and recorded separately regardless of whether the acquired set meets the
definition of a business.
2.049 The FASB included the exceptions in Step 1b to allow practical application of Step
1 in certain transactions. For example, in real estate transactions, land and buildings are
often transferred together but are considered separate assets for accounting purposes.
Without the first exception that requires the combination of tangible assets, these
transactions would rarely meet Step 1. The second exception was included to promote
consistency between real estate transactions in Step 1 so that an entity would not get a
different outcome for similar transactions solely because the value of the leases was
different or because the lease had above or below market rents.
2.050 We believe the exception for lease intangibles should be interpreted narrowly (i.e.,
it should be applied only when the contract meets the definition of a lease in ASC Topic
840, Leases, or ASC Topic 842, Leases, once adopted); entities should not make
analogies to combine other contracts and assets.
2.051 Additionally, we believe the reference to "an intangible asset representing the right
to use a tangible asset" in ASC paragraph 805-10-55-5B(a) is limited only to intangible
assets that represent a right to use a tangible asset that is physically attached to and
cannot be physically removed and used separately from another tangible asset without
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2. Identifying a Business Combination
incurring significant cost or significant diminution in utility or fair value of either asset.
Paragraph BC25 of ASU 2017-01 cites two examples that would qualify: (1) a building
and a related ground lease, and (2) a pipeline and the use rights for the land in which the
pipeline is laid. By contrast, we believe that intangible assets associated with a product
would not be combined with the related inventory, because they do not represent a right
to use a tangible asset that is physically attached to the inventory. The analysis in Case G
in ASC paragraphs 805-10-55-85 through 55-87 (see Example 2.17) appears to support
this view. In that example, the entity acquires the intellectual property rights to a yogurt
brand and the related equipment and inventory but does not combine those rights with the
tangible assets for the screening test.
Example 2.8b: Applying Step 1b
The following is a continuation of Example 2.8a.
Entity X evaluates whether any of the exceptions in ASC paragraph 805-10-55-5B (Step
1b) apply. Entity X concludes that the land, building, property improvements, and in-
place leases at each property (apartment complex) are a single asset for the following
reasons:
(1) The building and property improvements are attached to and cannot be physically
removed from and used separately from the land without incurring significant costs or
reducing their fair value; and
(2) The in-place lease intangibles for each apartment are required to be combined with
the leased asset.
After applying the exceptions, the set has six single identifiable assets (i.e., the combined
land, building, property improvements, and leases at each of the five properties are one
asset and the trade name intangible asset). The exceptions in Step 1b do not apply to the
trade name intangible asset.
Example 2.8bb: Applying Exception (a) in Step 1b
Entity A acquires Entity T. Based on its analysis of Step 1a, Entity A determines that the
acquired set consists of:
(1) An oil and gas processing plant, including the land, building and processing
equipment.
(2) A pipeline and related easement connecting the plant and terminal, which are located
5 miles from each other.
(3) An oil and gas terminal facility, including the land, building and storage tanks.
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2. Identifying a Business Combination
The pipeline is physically attached to components of both the processing plant and
terminal facility and connects the two facilities.
Entity A evaluates whether any of the exceptions in ASC paragraph 805-10-55-5B (Step
1b) apply to each of the identifiable assets from Step 1a. First, Entity A concludes that the
assets within each group of assets above should be combined for the following reasons:
(1) Processing plant – The processing plant building and processing equipment are
attached to and cannot be physically removed from and used separately from each
other and the land at the processing plant without incurring significant costs or
reducing their fair value;
(2) Pipeline – The pipeline is attached to land and the easement is the intangible right to
use the land attached to the pipeline;
(3) Terminal facility – The terminal building and storage tanks are attached to and cannot
be physically removed and used separately from each other and the land without
incurring significant costs or reducing their fair value.
Next, Entity A evaluates whether the three combined assets above should be further
combined into a single asset as follows:
— Processing plant and pipeline: Entity A concludes that the processing plant and
pipeline should be combined and considered a single asset (processing plant/pipeline)
because the pipeline is attached to and cannot be physically removed and used
separately from the processing plant without incurring significant cost or significant
diminution in utility or fair value to the pipeline.
— Combined processing plant/pipeline and terminal facility: Entity A concludes that the
terminal facility and processing plant/pipeline should be combined and considered a
single asset because the pipeline is attached to and cannot be physically removed and
used separately from the storage tanks at the facility without incurring significant cost
or significant diminution in utility or fair value to the pipeline.
Therefore, all of the identifiable assets in the set should be combined and considered a
single asset for the screening test.
Step 1c: Evaluate whether the remaining assets from Step 1b are similar assets
2.052 In Step1c, an entity evaluates whether the assets identified in Step 1b are similar.
However, an entity that acquires a combined single asset (e.g., the combined land,
building, property improvements, and leases in Example 2.8b) does not need to evaluate
components of that combined single asset for similarity. For example, it is not necessary
to consider whether the commercial and retail space in a single real estate asset are
different or similar. The analysis of significantly different risks is only about comparing
an individual or combined asset identified in Step 1b with another individual or combined
asset identified in Step 1b.
2.053 ASC paragraph 805-10-55-5C states, "When evaluating whether assets are similar,
an entity should consider the nature of each single identifiable asset and the risks
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2. Identifying a Business Combination
associated with managing and creating outputs from the assets (that is, the risk
characteristics)."
2.053a In addition, that paragraph identifies types of assets that should not be considered
similar, including:
(a) a tangible asset and an intangible asset,
(b) identifiable intangible assets in different major intangible asset classes (for
example, customer-related intangibles, trademarks, and in-process research
and development),
(c) a financial asset and a nonfinancial asset,
(d) different major classes of financial assets (for example, accounts receivable
and marketable securities),
(e) different major classes of tangible assets (for example, inventory,
manufacturing equipment, and automobiles), and
(f) identifiable assets within the same major asset class that have significantly
different risk characteristics.
2.054 ASC subparagraph 805-10-55-5-5C(a) states that a tangible asset and an intangible
asset should not be considered similar. This factor is applied only after assets are
combined in accordance with ASC paragraph 805-10-55-5B in Step 1b. Accordingly, an
entity does not need to separate a tangible and an intangible asset (e.g., real estate asset
and related lease intangible) in Step 1c when applying the above factors.
2.054a Furthermore, the individual combined assets (e.g., real estate asset and related
lease intangible) could be considered similar to other assets that are identified in Step 1b.
For example, a combined apartment complex and related leases would be compared to
other assets to determine if they are similar assets and may be grouped with other similar
combined assets (e.g., other combined apartment complexes and related leases) if the
other criteria to be a similar asset are met. Also, an apartment complex that is combined
with lease intangibles in Step 1b may be combined with a similar apartment complex
without leases if there are similar risks associated with managing and creating outputs
from the assets.
2.055 Significant judgment will be required to determine if single assets within a major
asset class have significantly different risk characteristics (factor (f)). Paragraph BC31 in
the Basis for Conclusions of ASU 2017-01 states, “The Board clarified that the risks to be
evaluated should be linked to the risks associated with the management of the assets and
creation of outputs because this assessment may be instructive on whether an integrated
set of assets and activities has been acquired. That is, when the risks associated with
managing and creating outputs from the assets are significantly different, the set would
need more sophisticated processes to manage and create outputs.” As a result, the
relevant analysis is whether the risks associated with creating outputs are significantly
different.
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2. Identifying a Business Combination
2.056 Consistent with ASC paragraph 805-10-55-8, we believe an entity should consider
the risks associated with the management of the assets and the creation of outputs from
the perspective of a market participant (see discussion of the market participant
perspective in Paragraph 2.093). It is not necessarily relevant how the acquirer intends to
operate the set, or how the seller operated the set, when determining the risks associated
with the assets.
2.057 An entity should consider different risk factors depending on the nature of the
asset. In paragraph BC32 of ASU 2017-01, the Board indicated its expectation that
different types of risks would be important to the analysis of different types of
transactions. For example, real estate and intellectual property have different risk
characteristics to analyze. Entities may also need to consider different types of risks for
assets within a particular industry.
2.057a A critical step in the analysis will often be identifying the most relevant risks
related to the assets. For example, we believe that the most relevant risks for intellectual
property under development (e.g., development risks) usually would be different from the
relevant risks associated with intellectual property embedded in a mature product (e.g.,
customer or market risks).
2.058 Table 2.4 summarizes risk factors and examples associated with operating and
managing the assets to create outputs that may be relevant based on the nature of the asset
(not exhaustive). These risks will need to be significant to affect the conclusion of
whether assets are similar, and while these factors may be present in a particular
transaction, they may not be determinative and all facts and circumstances should be
evaluated. We would expect more weight to be assigned to the most relevant risks
associated with the assets.
Table 2.4: Risk Factors and Examples to Consider When Identifying Similar
Assets
Type of
Assets
Risk Factors
Examples of Assets That May Have Significantly
Different Risks
Real Estate Geographic
location
Property in a developing or volatile economy versus a
stable and low volatility economy
Properties in jurisdictions or countries with significantly
different regulations
Single-family home in a large metropolitan area
(population > 2 million) versus single-family home in a
small town (population < 10,000)
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2. Identifying a Business Combination
Class of
customers
Four-star hotel versus a two-star hotel
Commercial office building versus residential property
Tenants with a high risk of default versus tenants with a
low risk of default
Size of the
properties
Office building with two floors versus an office building
with 30 floors
Shopping center (e.g., with five tenants) and a shopping
mall (with many tenants)
Market risk
Property in a high growth area versus a property in a low
growth area
Significant cost to obtain tenants versus property with a
waiting list to become a tenant
Types of
assets
Residential versus commercial real estate
Hotel versus commercial real estate
Apartment building versus a single-family home
Owned assets versus assets acquired under an operating
lease
Life
Sciences
Development
risk
Drug compounds in different phases of clinical trials (e.g.,
early versus late phase of clinical development)
Expertise required to develop the drug candidates
Science or technology underlying the drug candidates
Commercialized drug versus development stage
compound
Class of
customers
Drug compounds that treat (or are intended to treat)
different diseases (i.e., the patients have different
demographics)
Market risks
Generic brand versus premium brand
Commercialized product with generic competition versus
product with patent protection
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2. Identifying a Business Combination
Financial
Assets
Credit risk
High quality bond versus junk bond
Loan to a large multinational company with a high credit
rating versus a loan to a start-up company with a low
credit rating
Term
Type
Three-year loan versus a 20-year loan
Mortgage loan versus commercial loan
Oil and Gas
Assets
Development
risks
Property in shallow water versus property in ultra-deep
water
Jurisdiction
(laws and
regulations)
Property in location with known adverse weather
conditions versus property with moderate weather
conditions
Offshore properties versus onshore properties
Property in a highly regulated country versus property in
less regulated country
Property in country with unstable government versus
property in country with stable government
Property in area with access to a workforce (e.g., local
workforce available) and property in area with no
workforce (e.g., workforce must be transported to site)
Transport-
ation
Assets
Type of asset
Assets that perform different functions (e.g., cargo aircraft
versus a passenger aircraft)
Oil tanker and cargo ship
Market risks
Assets designed to operate in locations with known
adverse weather conditions versus assets designed to
operate in moderate weather conditions
Assets (e.g., newer models, better technology, or unique
functions) that demand higher rates from customers such
as a boat with a day rate of $30,000 versus a boat with a
day rate of $10,000
Example 2.8c: Applying Step 1c
The following is a continuation of Examples 2.8a and 2.8b.
The acquired apartment complexes are all in the same metropolitan area and have a
similar class of customers. There are differences in prices charged for apartments on
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2. Identifying a Business Combination
lower floors and apartments with a view. However, the ratio of price differences between
apartments on lower floors and apartments with views is reasonably consistent at each
apartment complex. The trade name intangible asset is not a similar asset to the apartment
complexes (i.e., tangible assets) as a tangible asset and an intangible asset (except for
lease intangibles and leased assets) are not similar per ASC paragraph 805-10-55-5C(a).
In applying ASC paragraph 805-10-55-5C, Entity X concludes that the five apartment
complexes are similar assets because the risks of operating the assets and creating outputs
from these assets are not significantly different.
As noted in the factors presented in Table 2.4, geographic location should be considered
when determining whether real estate assets are similar assets. Apartment complexes in
different parts of the United States or different parts of the same metropolitan area may
not be similar assets if the risks associated with producing outputs (e.g., lease income) in
different geographical locations are significantly different. Also, if there were another
type of asset acquired in the transaction such as an office building or hotel, it would not
be similar to apartment complexes.
Example 2.8cc: Acquisition of Owned and Leased Assets
As part of an acquisition, Entity A acquires two custom-made heavy machines from
Entity T. Machine X was owned by Entity T and Machine Y was under a finance lease
from an unrelated third party. Both machines are of the same make and model and used
for similar purposes in construction. Machine Y is leased for its entire economic life. As
part of steps 1a through 1b, the only two assets acquired in the set are Machine X and Y.
In applying ASC paragraph 805-10-55-5C, Entity A concluded that Machine X and Y
were similar because they were in the same major asset class and the risks of operating
the assets and creating outputs from these assets are not significantly different based on
the following:
— Same major class of tangible assets: Entity A concluded that both assets were in the
same major asset class because the nature or use in operations of each machine are
similar. While Entity A is required to separately classify or disclose finance lease
right of use (ROU) assets from the owned equipment, and the leased machine has
different accounting requirements, the nature of the underlying asset is similar.
Furthermore, because it is a finance lease it is economically similar to purchasing the
asset with cash or a different form of financing, as discussed in paragraph BC57 of
the Basis for Conclusions of ASU 2016-02.
— Similar risk characteristics: Entity A concluded that both machines had similar risk
characteristics because they can be used interchangeably by Entity A to create outputs
with similar customers over a similar time period. The way the machine was financed
does not significantly affect the risk of operating and managing the assets to create
outputs because the nature of a finance lease is similar to the purchase of an asset with
a corresponding financing.
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2. Identifying a Business Combination
If Machine Y was subject to an operating lease it may not be considered similar because
the time frame of operating and managing an asset under an operating lease may affect
the risks of managing and creating outputs compared to an owned asset.
Step 1d: Determine fair value of gross assets acquired
2.059 In Step 1d, the entity determines the fair value of gross assets acquired (i.e., the
denominator). The gross assets acquired generally include all assets that are recognized in
a business combination including goodwill. The denominator also includes consideration
transferred (plus the fair value of noncontrolling interests and previously held interests, if
any) in excess of the fair value of net identifiable assets acquired. The consideration
transferred would also include contingent consideration determined under ASC Topic
805 because contingent consideration may affect the value of goodwill, which is included
in gross assets. However, transaction costs are excluded from both the numerator and
denominator, because they are expensed in a business combination. Additionally, an
assembled workforce, which is not a recognized intangible asset in a business
combination, would be included in the denominator by virtue of its inclusion in goodwill.
2.060 The FASB specifically excluded items from the numerator and denominator such
as cash and cash equivalents, deferred tax assets, and goodwill resulting from the effects
of deferred tax liabilities. Cash and cash equivalents are excluded to prevent entities from
increasing the purchase price with no economic substance (e.g., by choosing to include a
greater amount of cash or cash equivalents in the acquired set) to avoid a conclusion that
substantially all of the fair value is concentrated in a single asset (or group of similar
assets).
2.060a The deferred tax items are excluded because those items are a reflection of the
legal or tax form of the transaction rather than the substance of what was acquired.
2.060b Except for unfavorable lease intangible liabilities, which are combined with the
related leased asset (see further discussion of leases in Paragraph 2.048), the numerator
and denominator exclude all debt or other liabilities because the assumption of those
liabilities may simply be a financing mechanism for the transaction. The Board indicated
in paragraph BC20 of ASU 2017-01 that it decided to exclude liabilities from the
screening test to avoid “a group of assets that would otherwise be subject to further
evaluation under the model bypassing such evaluation solely because a transaction
includes liabilities in addition to assets.” Following this rationale, we believe that a gain
from a bargain purchase also should be excluded from (i.e., it does not reduce) the
denominator. ASC paragraph 805-10-55-5A states that gross assets should include any
consideration transferred in excess of the fair value of net identifiable assets acquired.
ASC paragraph 805-10-55-5A does not specifically state that gross amounts should
include any deficit (i.e., bargain purchase amount). Including a bargain purchase amount
in the numerator and denominator would distort the screening test in a manner similar to
including liabilities. See Example 2.9a.
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2. Identifying a Business Combination
2.060c We believe that the exclusion of all liabilities (except for unfavorable lease
intangible liabilities) from the numerator and denominator of the screening test also
applies to asset retirement obligations related to assets included in the set. That is, an
asset retirement obligation should not be netted against (should not reduce) the fair value
of the assets included in the numerator and denominator. For example, assume an entity
acquires a set that includes a manufacturing facility with an associated asset retirement
obligation. The entity determines the fair value of the manufacturing facility to be $100
million (net of an asset retirement obligation of $20 million). In accounting for the
acquisition, the entity would record the manufacturing facility at $120 million and a
liability for the asset retirement obligation at $20 million. In applying the screening test,
the entity would include the manufacturing facility with a value of $120 million in both
the numerator and denominator. However, the presence of an asset retirement obligation
may be a relevant qualitative factor to consider (see factors discussed in Paragraph
2.063).
Example 2.8d: Applying Step 1d
The following is a continuation of Examples 2.8a, 2.8b, and 2.8c.
For this example, Entity X also assumes debt associated with building the apartment
complexes of $2,500,000 and cash on hand of $50,000. Company X paid a purchase price
of $25,600,000.
Entity X determines the fair value of the gross assets acquired to determine the
denominator.
Items Acquired / Assumed
Estimated Fair Value
Included in Gross Assets
Apartment complex 1
Apartment complex 2
Apartment complex 3
Apartment complex 4
Apartment complex 5
Assumed debt
Cash on hand
Trade names
Total
$5,100,000
$4,850,000
$5,650,000
$5,400,000
$5,200,000
($2,500,000)
$50,000
$1,850,000
$25,600,000
$5,100,000
$4,850,000
$5,650,000
$5,400,000
$5,200,000
Not included
Not included
$1,850,000
$28,050,000
The fair value of gross assets acquired is $28,050,000 in this example. Cash, debt
assumed, deferred taxes (if any), and goodwill resulting from the effects of deferred tax
liabilities (if any) are not included in gross assets acquired.
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2. Identifying a Business Combination
Step 1e: Compare the single identifiable asset or group of similar identifiable assets
to the fair value of gross assets acquired
2.061 In Step 1e, an entity compares the fair value of the single identifiable asset (or
group of similar assets) to the fair value of the gross assets acquired. To do that, an entity
would identify the individual identifiable asset with the greatest fair value or group of
similar identifiable assets with the greatest fair value (whichever is greater). Next the
entity compares that amount to the fair value of the gross assets acquired as determined in
Step 1d. If the fair value of that single identifiable asset or group of similar identifiable
assets represents substantially all of the fair value of the gross assets, then the screening
test is met and the set is not a business.
2.062 The FASB decided to use the term substantially all because it is commonly used
throughout U.S. GAAP. However, the FASB did not specify a quantitative threshold for
what substantially all means in Step 1. In other U.S. GAAP, substantially all is generally
interpreted to mean approximately 90 percent or greater; however, for purposes of the
definition of a business, substantially all is not necessarily meant to be a bright-line
quantitative threshold.
2.063 When there is uncertainty about whether the substantially all test is met (e.g.,
because the ratio is close to the quantitative threshold or the valuation of assets acquired
is based on unobservable (Level 3) fair value measurement inputs subject to significant
measurement uncertainty), we believe qualitative factors may also be considered. The
purpose of a qualitative assessment is to evaluate whether the other assets in the set have
substance, in which case Step 2 should be performed. We believe relevant qualitative
factors include but are not limited to the following:
• The composition of other assets.
•
•
If the other assets are equipment or materials that can be easily replaced at
a cost that is insignificant in relation to the fair value of the set, that may
qualitatively indicate that the substantially all threshold is met because the
other assets are not substantive.
If the other tangible or intangible assets complement the primary asset
(e.g., a customer list accompanying a significant developed technology
intangible asset), that may qualitatively indicate that the other assets are
substantive and an entity should move to Step 2.
• The set includes employees and goodwill. The presence of goodwill is an
indicator of a substantive process in the set. If the set includes employees and
a more than insignificant amount of goodwill, that may indicate that an entity
should move to Step 2 to evaluate whether the employees represent an
organized workforce, in which case a substantive process would be present and
the set likely would be a business.
• The set is self-sustaining. If the set is self-sustaining (i.e. the set was a stand-
alone entity or a largely independent division, subsidiary or product line of a
larger entity), that may qualitatively indicate that in substance an entity is
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48
2. Identifying a Business Combination
acquiring more than just a single asset and the other elements are substantive;
therefore the entity should move on to Step 2.
• An asset retirement obligation is included in the set. Asset retirement
obligations, although excluded from the substantially all quantitative test,
generally are associated with the normal operation of long-lived assets. If
exclusion of an asset retirement obligation associated with an asset in the set
is the reason a quantitative threshold has been met, that may qualitatively
indicate that in substance an entity acquired more than just a single asset and
the other elements are substantive depending on the nature and composition of
the other assets.
2.064 We would expect entities to apply the quantitative and qualitative factors
consistently to similar transactions. In general, we would place greater emphasis on the
quantitative assessment when there is a higher concentration of fair value in a single asset
(or group of similar assets) or the fair value measurements of the assets are not subject to
significant measurement uncertainty. As a result, qualitative factors ordinarily would not
overcome the quantitative assessment when the fair value of a single asset (or group of
assets) is well above 90 percent of the fair value of the gross assets even if employees are
included in the set. In contrast, we believe it would be rare for an entity to conclude that
Step 1 is met when the concentration of fair value is more than just a few percentage
points less than 90 percent of the fair value of the gross assets.
Example 2.8e: Applying Step 1e
The following is a continuation of Examples 2.8a, 2.8b, 2.8c, and 2.8d.
Entity X evaluates whether the fair value is concentrated in a single asset or group of
similar assets.
In Step 1d, the fair value of the gross assets acquired was determined to be $28,050,000.
The apartment complexes were found to be similar and are grouped together for Step 1.
In Step 1e, their combined value of $26,200,000 is compared to the gross assets acquired
of $28,050,000.
This results in 93 percent of the value of the gross assets acquired being associated with a
group of similar assets. Entity X also considers qualitatively whether in substance it
acquired a group of similar assets and whether the other elements are substantive. Entity
X determines the other elements (e.g., trade names) acquired are not substantive because
the other elements are not a result of goodwill and an organized workforce, and the set
was not a stand-alone self-sustaining operation.
The quantitative and qualitative factors indicate that, in substance, the entity acquired a
group of similar assets and the set is not a business.
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2. Identifying a Business Combination
Example 2.8f: Recognizing Certain Assets of a Medical Device Company as
a Single Asset for Financial Reporting Purposes
Entity B acquires Medical Device Corp. on December 15, 20X7. Medical Device has a
monopoly on a certain medical device product. The product has been on the market and
generating revenue for 20 years.
Entity B acquires all of the existing product technology, manufacturing equipment,
employees and supply contracts of the product line. The identifiable intangible assets
include technology, trade name, FDA approval and customer (doctor) relationships. The
trade name and customer relationship were determined to have nominal value. As Entity
B has a monopoly on the product, if it is medically necessary, doctors are compelled to
prescribe it as there are no alternatives. The technology and FDA approval are recognized
as a single asset (the "technology asset") by analogy to ASC subparagraph 805-20-55-
2(b), which indicates that a power plant and a license to operate that plant may be
recognized as a single asset if their useful lives are similar. The fair value of the
technology asset, goodwill, and other tangible assets represent 94%, 2%, and 4%,
respectively, of the fair value of the gross assets acquired.
Because the fair value of the technology asset is 94% of the fair value of the gross assets
acquired, Medical Device Corp concludes that substantially all of the fair value of the
gross assets is concentrated in a single identifiable asset. Step 1 is met and Step 2 is
unnecessary. The set is not a business.
Example 2.9: Applying Step 1 When Goodwill Results from the Effects of
Deferred Tax Liabilities
Entity A acquires 100% of Biotech Corp. on January 1, 20X9 for $10,000,000. Biotech's
operations include IPR&D activities on a single development stage drug compound. No
employees are included in the set. The enacted tax rate is 25% for 20X9 and all future
years.
The identifiable assets acquired and liabilities assumed have the following fair values and
tax bases.
Cash
IPR&D
Research lab
Current liabilities, excluding
deferred taxes
Estimated
Fair Value
$50,000
$9,450,000
$400,000
Tax Basis
Temporary
Difference
$50,000
$0
$200,000
$0
$9,450,000
$200,000
($200,000)
($200,000)
$0
Identifiable net assets acquired
$9,700,000
$50,000
$9,650,000
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The assets acquired and liabilities assumed would be recognized (under ASC Topic 805)
as follows:
2. Identifying a Business Combination
Cash
IPR&D
Research lab
Current liabilities
Deferred tax liabilities
Goodwill
Consideration paid
Step 1a
$50,000
$9,450,000
$400,000
($200,000)
($2,412,500)
$2,712,500
$10,000,000
Entity A determines the identifiable assets that could be recognized separately in a
business combination. As shown above, the identifiable assets in the set include cash,
IPR&D, and the research lab.
Step 1b
Entity A evaluates whether any of the exceptions in ASC paragraph 805-10-55-5B (Step
1b) apply. Entity A concludes that none of the assets meet the exceptions and none of the
acquired assets are combined.
Step 1c
In applying ASC paragraph 805-10-55-5C, Entity A concludes that none of the acquired
identifiable assets (e.g., cash, IPR&D, and the research lab) are similar assets.
Step 1d
In applying Step 1d, the gross assets acquired would not include the goodwill associated
with the deferred tax liabilities acquired in this transaction. The deferred tax liabilities
acquired in this example generated $2,412,500 of goodwill, which is excluded for
purposes of applying Step 1, leaving $300,000 of goodwill.
The gross assets acquired in this example for purposes of Step 1 are as follows:
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2. Identifying a Business Combination
Items Acquired / Assumed
Value under ASC Topic
805
Included in Gross Assets
Cash
IPR&D
Research lab
Current liabilities
Deferred tax liabilities
Goodwill
Total
$50,000
$9,450,000
$400,000
($200,000)
($2,412,500)
$2,712,500
$10,000,000
Not included
$9,450,000
$400,000
Not included
Not included
$300,000
$10,150,000
The fair value of gross assets acquired is $10,150,000.
Step 1e
Entity A evaluates whether the fair value is concentrated in a single asset or group of
similar assets.
In Step 1d, the fair value of the gross assets acquired was determined to be $10,150,000.
As previously discussed, none of the acquired assets were found to be similar and none
are grouped together for Step 1c. In Step 1e, the largest acquired asset had a value of
$9,450,000 and is compared to the gross assets acquired of $10,150,000.
This results in 93 percent of the value of the gross assets acquired being associated with a
single identifiable asset (e.g., IPR&D). Entity A also considers qualitatively whether in
substance the other elements (e.g., research lab, goodwill) of the transaction are
substantive. While the set includes goodwill, the value associated with the goodwill is de
minimis (below 3 percent) and is not attributable to an organized workforce because
there are no employees acquired. As a result, the quantitative and qualitative factors
indicate that substantially all the fair value is concentrated in a single asset and the set is
not a business.
Example 2.9a: Applying the Step 1 Threshold (Initial Screening) Test When
a Bargain Purchase Exists
ABC Corp. enters into a purchase agreement to acquire a small software company
(Target) for $9,000,000. Target has five employees that are all software developers, earns
some revenue, but is not profitable. Target’s owners believe its software alone is worth
more than the purchase price. However, Target is running out of money, and its owners
are willing to sell to ABC at a significant discount.
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2. Identifying a Business Combination
Target’s software has a fair value of $10,000,000 and it has a customer-related intangible
with a fair value of $500,000.
ABC’s senior management and IT department believe Target’s five software developer
employees can be replaced after consummation of the transaction without significant
time, effort or delay in the ability to continue producing outputs, as they are not
considered essential (e.g., the software is already developed).
ABC determines that it should exclude the bargain purchase amount from the numerator
and denominator in Step 1 (see Paragraph 2.060b). Because an assembled workforce is
not a recognized identifiable asset in a business combination (and because there is no
goodwill in this example), ABC will exclude the assembled workforce from Step 1.
ABC performs Step 1 to evaluate whether the fair value is concentrated in a single asset
or group of similar assets.
Items Acquired
Value Under ASC Topic
805
Included in Gross Assets
Software
Customer-related intangible
Bargain purchase
Total
$10,000,000
$500,000
$(1,500,000)
$9,000,000
$10,000,000
$500,000
Not included
$10,500,000
ABC compares the largest acquired asset (software) valued at $10,000,000 to the fair
value of gross assets acquired of $10,500,000.
This results in 95% of the value of the gross assets acquired being associated with a
single identifiable asset. ABC also evaluates whether qualitatively, the other elements
(customer-related intangible and employees) are substantive. There is no goodwill
associated with the set (i.e., there is no value in the assembled workforce because the
employees can easily be replaced) and the value of a single asset is well above 90%.
ABC concludes that substantially all the fair value is concentrated in a single asset and
the set is not a business.
2.065 Paragraph not used.
Example 2.10: Acquisition of Loan Portfolio – Scenario 11
Facts
• Bank A acquires a portfolio of residential mortgages and a portfolio of
commercial mortgages, each having significant value and significantly
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2. Identifying a Business Combination
different risks (e.g., term, size, and risk ratings).
• Bank A does not acquire the employees that managed the credit risk of the
loan portfolios and had relationships with the borrowers in the acquisition.
Bank A does not acquire other protocols, conventions, or systems.
• The loan portfolios currently produce outputs (interest income).
Analysis
Step 1 (Screening Test):
Bank A concludes that substantially all of the fair value of the gross assets acquired is not
concentrated in a single or a group of similar identifiable asset(s). This is because the two
loan portfolios have significantly different risk characteristics and are not similar assets.
The fair value of the gross assets is spread across the two identifiable assets (loan
portfolios); therefore, Step 1 is not met.
See Example 2.15 for the analysis of Step 2.
Conclusion
The acquired set does not meet the screening test (Step 1); therefore, Step 2 is required.
Alternatively, because no employees, protocols, conventions or systems were acquired, it
is clear that the set does not include an organized workforce or an acquired process. Bank
A could have elected to bypass the screening test (and the necessary assessment of
similarity of risk characteristics) and gone directly to Step 2 to conclude the set is not a
business. This alternative analysis applies only when it is clear that the set would not be a
business under Step 2. An entity may not skip Step 1 if it's clear that there is an input and
a substantive process, because the screening test could still lead to a conclusion that the
set is not a business.
Example 2.11: Acquisition of Oil and Gas Properties – Scenario 1
Facts
• XYZ Co. acquires the mineral rights (i.e., lease agreements to develop and
produce the underlying mineral reserves) in certain properties in the southwest
shale.
• The acquisition provides XYZ Co. with an average 50% working interest in
the properties.
• The properties are proved and unproved properties. The proved properties are
currently producing oil and gas. The properties classified as unproved have
known reserves (they have been proved up) but are classified as unproved
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2. Identifying a Business Combination
because of the requirement to classify properties as unproved if an entity does
not expect to produce from those properties within the next five years.
• XYZ Co. also assumes customer contracts in the acquisition, which are at
market rates. No employees are in the set.
Analysis
Step 1 (Screening test)
The oil and gas properties are found to be two single identifiable assets that would be
recognized in a business combination under Topic 805. The two assets are proved and
unproved properties. Even though they have different disclosure requirements, we believe
that proved and unproved oil and gas properties can be considered to be within the same
major asset class and therefore could be considered similar assets if they do not have
significantly different risks. When evaluating whether those assets are similar, an entity
should consider the nature of proved and unproved properties and the risks associated
with managing and creating outputs from the proved and unproved properties (i.e., the
risk characteristics).
In this example, the two identified assets do not have significantly different risks
associated with creating outputs and therefore are similar assets. They are similar assets
because they are in the same geographic area (e.g., southwest shale) and are expected to
have similar outputs (e.g., mix of hydrocarbons) from both assets. The unproved
properties, while not meeting the proved definition because XYZ Co. does not expect to
produce from those properties over the next five years, are considered to have the same
risk profile as the proved properties because they have known reserves.
If the unproved properties had not already been proved up, XYZ Co. may have concluded
that the proved and unproved properties have significantly different risks.
Additionally, oil and gas properties in different regions of the United States, in different
jurisdictions, and those that have different characteristics such as offshore and onshore
could result in different conclusions about whether they are similar and would require
analysis of the specific facts and circumstances.
There is no fair value associated with the customer contracts because the contracts are at
market rates and are readily available in the market place, and there were no other assets
acquired. Accordingly, XYZ Co. concludes that substantially all of the fair value of the
gross assets acquired is concentrated in a group of similar identifiable assets (the proved
and unproved oil and gas properties). Step 1 is met and the set is not a business.
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2. Identifying a Business Combination
Example 2.11a: Acquisition of Petroleum Storage Facilities
Facts
• ABC Co. (ABC) enters into an asset purchase agreement with DEF Co. (DEF)
for total consideration of $500 million.
• DEF will transfer to ABC the following:
• Two petroleum storage and distribution terminal facilities located along
the Oregon coastline; and
• Customer relationships and fixed assets comprised of automobiles,
equipment, tools and IP equipment.
• The set has revenues from both facilities that will continue after the
acquisition.
• The type and class of customers are similar for the facilities.
Analysis
Step 1 (threshold test)
The land, buildings, storage tanks, and interconnecting pipes at each facility are attached
to each other and cannot be physically removed from and used separately from one
another without incurring significant cost or reducing their fair value. As such, they are
considered to be a single asset for the screening test.
The next step is to determine if the two petroleum storage and distribution terminal
facilities are similar assets. The two identified facilities do not have significantly different
risks associated with creating outputs. They are in the same geographic area (e.g., Oregon
coastline), both on-shore properties, both expected to have similar outputs (e.g., crude oil
and refined petroleum products) from both assets and the type and class of customers are
similar for the assets. As such, they are similar assets and grouped together for the
screening test.
ABC next compares the largest acquired group of similar assets (petroleum storage and
distribution facilities) valued at $483,000,000 to the fair value of gross assets acquired of
$500,000,000.
Items Acquired
Petroleum storage and distribution facilities
Customer-related intangibles and fixed
assets
Total
Estimated
Fair Value
Included in
Gross Assets
$483,000,000
$483,000,000
$17,000,000
$500,000,000
$17,000,000
$500,000,000
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2. Identifying a Business Combination
Items Acquired
Percentage
Petroleum storage and distribution facilities
Customer-related intangibles and fixed
assets
Total
96.6%
3.4%
100%
Because 96.6% of the fair value of the gross assets acquired is concentrated in the group
of similar assets, ABC concludes that the substantially all test (step 1) is met and the set
is not a business.
Step 2 (input and substantive process)
Step 2 is not necessary in this scenario.
Conclusion
ABC concludes the transaction is an asset acquisition rather than a business combination
because substantially all the fair value is concentrated in a group of similar assets.
Example 2.11b: Acquisition of a Property Subject to a Tax Abatement
Facts
• ABC Co. (ABC) constructed a new facility and entered into a property tax
abatement agreement with the local government.
• The term of the property tax abatement is 30 years.
• ABC enters into an asset purchase agreement with DEF Co. (DEF) where
DEF acquires the facility (land and building) and the related property tax
abatement.
• There is no goodwill or other assets in the set.
• The FV of the facility is $10,000,000 and the FV of the property tax
abatement is $2,500,000.
Analysis
To apply Step 1, DEF evaluates whether the set includes a single identifiable asset or a
group of similar assets.
Step 1a
DEF concludes that the identifiable assets in the set include the land, building and
property tax abatement. The abatement is an identifiable intangible asset under ASC
Topic 805 because it meets the contractual-legal criterion.
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2. Identifying a Business Combination
Step 1b
The land and building are combined under ASC paragraph 805-10-55-5B for the
screening test because they are attached to and cannot be physically removed and used
separately from each other without incurring significant costs or reducing their fair value.
However, the property tax abatement does not meet one of the exceptions in ASC
paragraph 805-10-55-5B and is not combined with the land and building into a single
identifiable asset. Although the property tax abatement was derived from the
construction of the facility and is an intangible asset related to the property, it does not
represent the right to use the land or building and is not a lease.
Step 1c
The facility (combined land and building) is a tangible asset and the property tax
abatement is an intangible asset. Therefore, the two assets cannot be considered similar.
Step 1d
The fair value of the gross assets acquired is $12,500,000.
Step 1e
DEF compares each of the single identified assets to the gross assets acquired. The fair
value of the facility compared to the gross assets acquired is 80%
($10,000,000/$12,500,000) and the fair value of the property tax abatement is 20% of the
gross assets acquired. DEF concludes that substantially all the fair value of the gross
assets acquired is not concentrated in a single asset or group of similar assets.
Conclusion
The acquired set does not meet the screening test (Step 1); therefore, Step 2 is required.
STEP 2 – EVALUATE WHETHER AN INPUT AND A SUBSTANTIVE PROCESS
EXIST
Framework – Inputs, Substantive Processes, and Other Considerations
ASC paragraph 805-10-55-5D
When a set does not have outputs (for example, an early stage company that has
not generated revenues), the set will have both an input and a substantive process
that together significantly contribute to the ability to create outputs only if it
includes employees that form an organized workforce and an input that the
workforce could develop or convert into output. The organized workforce must
have the necessary skills, knowledge, or experience to perform an acquired
process (or group of processes) that when applied to another acquired input or
inputs is critical to the ability to develop or convert that acquired input or inputs
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2. Identifying a Business Combination
into outputs. An entity should consider the following in evaluating whether the
acquired workforce is performing a substantive process:
(a) A process (or group of processes) is not critical if, for example, it is
considered ancillary or minor in the context of all the processes required to
create outputs.
(b) Inputs that employees who form an organized workforce could develop (or are
developing) or convert into outputs could include the following:
(1) Intellectual property that could be used to develop a good or service
(2) Resources that could be developed to create outputs
(3) Access to necessary materials or rights that enable the creation of future
outputs.
Examples of inputs that could be developed include technology, mineral
interests, real estate, and in-process research and development.
ASC paragraph 805-10-55-5E
When the set has outputs (that is, there is a continuation of revenue before and
after the transaction), the set will have both an input and a substantive process that
together significantly contribute to the ability to create outputs when any of the
following are present:
(a) Employees that form an organized workforce that has the necessary skills,
knowledge, or experience to perform an acquired process (or group of
processes) that when applied to an acquired input or inputs is critical to the
ability to continue producing outputs. A process (or group of processes) is not
critical if, for example, it is considered ancillary or minor in the context of all
of the processes required to continue producing outputs.
(b) An acquired contract that provides access to an organized workforce that has
the necessary skills, knowledge, or experience to perform an acquired process
(or group of processes) that when applied to an acquired input or inputs is
critical to the ability to continue producing outputs. An entity should assess
the substance of an acquired contract and whether it has effectively acquired
an organized workforce that performs a substantive process (for example,
considering the duration and the renewal terms of the contract).
(c) The acquired process (or group of processes) when applied to an acquired
input or inputs significantly contributes to the ability to continue producing
outputs and cannot be replaced without significant cost, effort, or delay in the
ability to continue producing outputs.
(d) The acquired process (or group of processes) when applied to an acquired
input or inputs significantly contributes to the ability to continue producing
outputs and is considered unique or scarce.
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2. Identifying a Business Combination
ASC paragraph 805-10-55-5F
If a set has outputs, continuation of revenues does not on its own indicate that
both an input and a substantive process have been acquired. Accordingly,
assumed contractual arrangements that provide for the continuation of revenues
(for example, customer contracts, customer lists, and leases [when the set is the
lessor]) should be excluded from the analysis in [ASC] paragraph 805-10- 55-5E
of whether a process has been acquired.
ASC paragraph 805-10-55-6
The nature of the elements of a business varies by industry and by the structure of
an entity’s operations (activities), including the entity’s stage of development.
Established businesses often have many different types of inputs, processes, and
outputs, whereas new businesses often have few inputs and processes and
sometimes only a single output (product). Nearly all businesses also have
liabilities, but a business need not have liabilities. In addition, some transferred
sets of assets and activities that are not a business may have liabilities.
ASC paragraph 805-10-55-8
Determining whether a particular set of assets and activities is a business should
be based on whether the integrated set is capable of being conducted and managed
as a business by a market participant. Thus, in evaluating whether a particular set
is a business, it is not relevant whether a seller operated the set as a business or
whether the acquirer intends to operate the set as a business.
ASC paragraph 805-10-55-9
When evaluating whether a set meets the criteria in [ASC] paragraphs 805-10-55-
5D through 55-5E, the presence of more than an insignificant amount of goodwill
may be an indicator that the acquired process is substantive and, therefore, the
acquired set is a business. However, a business need not have goodwill.
2.066 In Step 2, a set must include, at a minimum, an input and a substantive process that
together significantly contribute to the ability to create outputs. The guidance provides a
framework to assist entities in evaluating whether both an input and a substantive process
are present and gives examples about applying the implementation guidance.
2.067 The first decision point is to determine if the set has outputs. The guidance has a
different set of criteria depending on whether the set has outputs. Outputs are the result of
inputs and processes applied to those inputs that provide goods or services to customers,
investment income (e.g. dividends, interest), or other revenues. Although outputs are not
required for a set to be a business, outputs are one of the three elements of a business.
The FASB created a more stringent set of criteria when outputs are not present.
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2. Identifying a Business Combination
2.067a Based on informal discussions, we understand that the FASB staff believes it is
acceptable for an acquirer to evaluate a set of assets and activities with only
inconsequential outputs as a set without outputs. Judgment is required and an acquirer
may also need to consider qualitative aspects. For example, we believe it generally would
be appropriate to evaluate a start-up with only minimal outputs that is ramping up central
activities as a set with outputs. Conversely, we believe it generally would be appropriate
to evaluate a set with only minimal outputs that is winding down activities as a set
without outputs.
2.067b Determining whether one or more inputs exist is usually straightforward.
Accordingly, the discussion below focuses primarily on determining whether a
substantive process exists.
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2. Identifying a Business Combination
Acquired Set with No Outputs (ASC paragraph 805-10-55-5D)
2.068 For a set with no outputs (e.g., an entity in the development stage that has not
generated revenues) to have both an input and substantive process, it must include:
(a) Employees that form an organized workforce; and
(b) An input that the workforce could develop or convert into outputs.
2.069 The employees that form the organized workforce must have the necessary skills,
knowledge, or experience to perform an acquired process (or group of processes) that
when applied to another acquired input or inputs is critical to the ability to develop or
convert that acquired input or inputs into outputs.
Organized Workforce
2.070 The organized workforce must consist of employees. An acquired contract that
performs a process would not on its own be considered an organized workforce when a
set does not have outputs. However, if the set includes both employees and service
contracts, the processes performed by the vendor may be considered a critical process.
For example, paragraph BC48 of the Basis for Conclusions of ASU 2017-01 states, "The
Board also noted that a critical process performed by employees could include the
management of service providers. The Board stated that, as an example, an entity should
come to consistent conclusions when evaluating a set that has 100 employees and a set
that has 20 employees with the equivalent of 80 employees replaced by outsourced
service providers because the 20 employees would be responsible for the management
and performance of the outsourced employees."
2.071 ASC paragraph 805-10-55-5D(a) states that a process (or group of processes) is not
critical if, for example, it is considered ancillary or minor in the context of all the
processes required to create outputs. However, the FASB did not provide additional
guidance and as a result, determining whether the acquired workforce is performing a
critical process will require significant judgment.
2.072 We believe the analysis of whether the process is critical should focus on the nature
of the process being performed by the workforce. To evaluate whether the process is
critical or minor, entities may compare the process being performed by the workforce to
the missing processes from the set. If the acquired process (or group of processes) is
considered qualitatively and quantitatively minor compared to all of the processes
required to produce outputs, the process would not be critical. The following factors may
indicate that the employees are performing a process that is critical to developing or
converting inputs into outputs (none of which individually would be determinative):
• Size of the workforce. The greater the number of employees, the more likely
the process is substantive. However, the number of employees is not
determinative as a few employees might have significant knowledge,
experience, or skills that are critical to developing the acquired inputs into
outputs.
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2. Identifying a Business Combination
• Stage of activities. If the organized workforce has not yet commenced
activities to develop or convert inputs into outputs, it could call into question
whether the processes acquired are in fact substantive or could be used to
develop or convert the inputs into outputs. In contrast, if the organized
workforce has commenced key activities to develop or convert inputs into
outputs, the processes being performed would likely be critical.
• Research and development activities. The process may be substantive if the
organized workforce has employees with necessary skills, knowledge, or
experience in performing research and development processes that are
significant to converting inputs into outputs. In an entity without outputs,
research and development activities are likely to be one of an entity's most
significant processes in the development stage. Example 2.13 below illustrates
an example where research and development processes performed by acquired
scientists are critical to the development of intellectual property.
• How close the set is to generating revenues. If the entity is close to
generating revenues, the processes the employees are performing are more
likely to be critical to developing or converting the inputs into outputs. The
workforce may not be critical if there is significant uncertainty about its
knowledge, skills, experience, or ability to complete the required steps to turn
the inputs into outputs. For example, the need to hire a significant number of
employees after the acquisition with the necessary knowledge, skills, or
experience to continue the activities required to develop or convert the
acquired inputs into outputs could indicate that the processes performed by the
acquired workforce are not critical.
• Whether the set is self-sustaining and operated on a stand-alone basis. If
the set includes an organized workforce that was operating the set on a stand-
alone basis (i.e., it was not a division, subsidiary, product line, or portion of a
larger entity), the organized workforce may be performing critical processes
to manage and operate the set. This factor does not refer to the entity's
financing needs or ability to access capital.
• Presence of goodwill. The presence of goodwill in a set with no outputs may
indicate that the organized workforce is performing a critical process.
• Process of integrating multiple assets. If the employees are performing
resource allocation, strategic management, or operational processes that
manage different risks to integrate multiple different assets to develop inputs
into outputs, the process is likely critical.
Inputs That the Entity Could Convert into Outputs
2.073 Acquiring employees is not enough to conclude that a set with no outputs is a
business. That acquired workforce must be able to develop or convert another acquired
input or inputs into outputs. As a result, the set also must include an input or inputs that
could be developed or converted (or are being developed or converted) into outputs.
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2. Identifying a Business Combination
These inputs include but are not limited to items such as technology, drug compounds,
real estate, oil and gas properties, and distribution or production rights.
2.074 These types of assets form the foundation of what would ultimately be the goods or
platform for the services to be provided to customers. Assets such as equipment that
could be used to convert other inputs (e.g., a piece of machinery used to manufacture a
good) may not be sufficient on their own because those inputs generally are not
developed or converted into outputs and are used only to convert another input into
outputs.
Example 2.12: Acquisition of a Drug Candidate – Scenario 12
Facts
• Pharma Co. acquired two development stage drug compounds from Biotech
that treat different illnesses.
• The two drug compounds each have significant value and significantly
different risks (e.g., they treat different illnesses, have different patient
subsets, and have different expected lives).
• Pharma Co. also assumes from Biotech their (1) clinical research organization
(CRO) contract and (2) clinical manufacturing organization (CMO) contract.
• Pharma Co. does not acquire the scientists and long-lived tangible assets.
• Biotech is not currently generating revenues.
Analysis
Step 1 (Screening Test):
Pharma Co. concludes that substantially all of the fair value of the gross assets acquired is
not concentrated in a single or a group of similar identifiable assets. Pharma Co. notes
that the nature of the IPR&D activities is similar. However, Pharma Co. concludes that
each activity has significantly different risks associated with creating outputs because
each activity has different risks associated with developing and marketing the compound
to customers.
Pharma Co. also concludes that there is no fair value associated with the CRO and CMO
contracts because the services are provided at market rates and could be provided by
multiple vendors. Therefore, all of the consideration in the transaction will be allocated to
the IPR&D activities.
The fair value of the gross assets is spread across the two identifiable IPR&D assets
because these assets are not similar for the purposes of applying the screening test. Step 1
is not met.
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2. Identifying a Business Combination
Step 2 (Input and Substantive Process):
When there are no outputs, there must be inputs and employees (an acquired contract that
represents an organized workforce is not sufficient). Accordingly, the acquired CRO and
CMO contracts are not relevant to the Step 2 analysis because there are no outputs in the
set. Pharma Co. concludes that the criteria in ASC paragraph 805-10-55-5D to determine
whether the set has both an input and a substantive process are not met because the set
does not have employees.
Conclusion
The acquired set is not a business because the set does not include employees that
represent an organized workforce with the necessary skills, knowledge, or experience to
perform an acquired process (or group of processes) that when applied to another
acquired input or inputs is critical to the ability to develop or convert that acquired input
or inputs into outputs.
Example 2.13: Acquisition of Biotech – Scenario 13
Facts
• Pharma Co. acquires the outstanding shares of Biotech, whose operations
include IPR&D activities on several development stage drug compounds. The
compounds target different illnesses and patient subsets.
• Pharma Co. also acquires long-lived tangible assets such as a corporate
headquarters, a research lab, and testing equipment.
• Pharma Co. concludes there is significant fair value in the acquired workforce,
the different IPR&D projects, and tangible assets.
• The set includes the scientists with the necessary skills, knowledge, or
experience to continue to perform R&D activities.
• There is also a more-than-insignificant amount of goodwill.
• Biotech has not generated revenues.
Analysis
Step 1 (Screening Test):
Pharma Co. concludes that substantially all of the fair value of the gross assets acquired is
not concentrated in a single or a group of similar identifiable assets. Pharma Co. notes
that the nature of the IPR&D activities is similar. However, Pharma Co. concludes that
each activity has significantly different risks associated with creating outputs because
each activity has different risks associated with developing and marketing the compound
to customers.
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2. Identifying a Business Combination
In addition, there is significant fair value in different asset classes: intangible (IPR&D
assets) and tangible (the headquarters, the research lab, and testing equipment). Step 1 is
not met.
Step 2 (Input and Substantive Process):
When there are no outputs, there must be inputs and employees. Pharma Co. concludes
that the scientists make up an organized workforce with the necessary skills, knowledge,
or experience to perform R&D processes. Those processes, when applied to the IPR&D
inputs, are critical to the ability to develop the inputs into outputs.
There is also a more-than-insignificant amount of goodwill, which indicates the
workforce is performing a critical process.
Conclusion
The acquired set is a business because the set includes employees that represent an
organized workforce with the necessary skills, knowledge, or experience to perform an
acquired process that when applied to acquired inputs (IPR&D) is critical to the ability to
develop those inputs into outputs.
Example 2.13a: Acquisition of Professional Service Employees
Facts
ABC Co. acquires 100% of the outstanding shares of Sub Co. from DEF Co. for
consideration of $2 million in cash. Sub has 35 employees from a service line that DEF is
discontinuing and holds no assets. ABC will retain the employees to integrate into its
operations.
Analysis
Step 1 (Screening Test):
ABC concludes that substantially all of the fair value of the gross assets acquired is not
concentrated in a single asset or a group of similar assets. The employees represent an
assembled workforce, but an assembled workforce would not be recognized as a separate
asset in a business combination. Rather, it would be subsumed into goodwill, and
goodwill is excluded from the numerator of the screening test.
Step 2 (Input and Substantive Process):
ABC evaluates Sub as a set that does not have outputs, because there is no continuation
of revenues. The set includes an assembled workforce; however, there are no inputs in the
set for the employees to turn into outputs.
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2. Identifying a Business Combination
Conclusion
The acquired set is not a business because the set does not include inputs. ABC
recognizes an intangible asset for the assembled workforce it acquires.
Example 2.13b: Intent to Restructure Workforce Post-Acquisition
Facts
• Widget Co. acquires the outstanding shares of Acme Co., an early stage
competitor of Widget that also plans to manufacture and sell widgets.
• Acme has not started manufacturing widgets or generated any revenues.
• Widget also acquires long-lived tangible assets such as a corporate
headquarters, manufacturing facilities, equipment and raw materials.
• Widget's intent of the acquisition is to acquire the manufacturing facilities,
equipment and raw materials to expand its production capacity.
• The set includes employees with the necessary skills, knowledge, or
experience to manufacture and sell widgets, however Widget already has an
established workforce to manufacture and sell widgets.
• Widget intends to implement a significant restructuring plan after the
acquisition to eliminate the redundancies between the two companies that
includes terminating substantially all of the Acme workforce.
• Widget concludes there is significant fair value in the acquired workforce
(although it has plans to terminate substantially all of the workforce) and
tangible assets.
• There is also a more-than-insignificant amount of goodwill.
Analysis
Step 1 (Screening Test):
Widget concludes that substantially all of the fair value of the gross assets acquired is not
concentrated in a single asset or a group of similar identifiable assets, because it acquires
a variety of assets in different classes, all with substantial fair value. Step 1 is not met.
Step 2 (Input and Substantive Process):
When an acquired set has no outputs, there must be inputs and employees that constitute
an organized workforce to conclude the set is a business. Although Widget decided
before the acquisition to terminate all of Acme's employees, the restructuring is for the
benefit of Widget and not executed until after the acquisition. Therefore, Widget
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2. Identifying a Business Combination
considers terminating the employees to be a separate transaction rather than part of the
acquisition and the employees are considered part of the set.
There is also a more-than-insignificant amount of goodwill, which indicates the
workforce is capable of performing a critical process.
Conclusion
The acquired set is a business because the set includes employees that represent an
organized workforce with the necessary skills, knowledge, or experience to perform
widget manufacturing and selling processes that, when applied to the acquired inputs
(manufacturing facilities, equipment and raw materials), are critical to the ability to
develop those inputs into outputs.
Acquired Set with Outputs (ASC paragraph 805-10-55-5E)
2.075 When the set has outputs, only one of the factors in ASC paragraph 805-10-55-5E
needs to be present for a set to have a substantive process. The set will have both an input
and a substantive process when any of the following are present:
(a) Employees that form an organized workforce with the necessary skills,
knowledge, or experience to perform an acquired process (or group of
processes) that when applied to an acquired input or inputs is critical to the
ability to continue producing outputs;
(b) An acquired contract that provides access to an organized workforce with the
necessary skills, knowledge, or experience to perform an acquired process (or
group of processes) that when applied to an acquired input or inputs is critical
to the ability to continue producing outputs;
(c) The acquired process (or group of processes) when applied to an acquired
input or inputs significantly contributes to the ability to continue producing
outputs and cannot be replaced without significant cost, effort, or delay in the
ability to continue producing outputs; or
(d) The acquired process (or group of processes) when applied to an acquired
input or inputs significantly contributes to the ability to continue producing
outputs and is considered unique or scarce.
2.076 ASC paragraph 805-10-55-5E does not specifically state types of inputs that must
be acquired because by definition a set that has outputs would have an input (or inputs)
that could be converted into outputs. However, the process acquired must relate to an
acquired input because all of the factors require that the process acquired be applied to an
input in the acquired set.
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2. Identifying a Business Combination
Organized Workforce Consisting of Employees
2.077 Similar to sets with no outputs, a set that has outputs is a business when it includes
an organized workforce that consists of employees that have the necessary skills,
knowledge, or experience to perform an acquired process (or group of processes) that
when applied to an acquired input or inputs is critical to the ability to continue producing
outputs. While employees are an input, they can also provide a process (see Paragraph
2.030) if they constitute an organized workforce. However, to be a business, we believe
the workforce must perform a process on another acquired input. That is, the employees
cannot be the only input in the set.
2.078 An entity would perform a similar evaluation of whether the acquired process
(employees that make up an organized workforce) is critical as it would if the set did not
have outputs (see Paragraph 2.072). However, the focus of the analysis is on whether that
process is critical to the continuation of outputs. The following factors may indicate that
the acquired process is considered critical:
• Involvement in fulfillment activities. If the workforce is directly involved in
fulfillment of providing goods or services or obtaining customers, that would
indicate that the acquired process is critical to continuing to produce outputs.
For example, an entity acquires a set with a workforce that is directly involved
in generating new customers, producing goods sold (manufacturing
employees), or fulfilling a service to the customers (customer-facing
employees providing the service).
• Skillset of the workforce. If the workforce has specialized skills or
knowledge required to perform operational processes needed to continue
producing outputs, that would be an indicator that the workforce is critical.
The specific skills of the workforce must be considered in light of the set's
activities. For example, a group of cleaning employees might be very skilled
at cleaning; however, if the business activities of the set are not cleaning
services, they usually would not be performing a process that is critical to
continuing to produce outputs.
• Size of the workforce. The greater the number of employees the more likely
the process is to be substantive. However, the number of employees is not
determinative because a few employees might have significant knowledge,
experience, or skills that are critical to continuing to produce outputs.
• Ability to operate on a stand-alone basis. If the set includes an organized
workforce that was operating the set on a stand-alone basis (i.e., it was not a
division, subsidiary, product line, or portion of a larger entity), the organized
workforce may be performing processes critical to continuing to produce
outputs. This factor does not refer to the entity's financing needs or ability to
access capital.
• Presence of goodwill. The presence of goodwill may indicate that the
organized workforce is performing a critical process.
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2. Identifying a Business Combination
• Strategic management process. If the processes performed are strategic
management processes that involve determining the strategy for creating
outputs, setting the price with customers, or determining the types of goods or
services to sell to customers, that may indicate that the acquired processes are
critical.
• Resource allocation process. If the organized workforce is performing
resource allocation processes to facilitate the delivery of goods or services to
customers, these processes may be critical to continue producing outputs.
• The number of processes acquired. While only a single substantive process
is required for a set to be a business, the more processes the organized
workforce is performing, the more likely the group of processes together
would be considered critical.
• Process of integrating multiple assets. If the process acquired includes
resource allocation, strategic management, or operational processes that
manage different risks to integrate multiple different assets to continue
producing outputs, those processes would likely be considered critical.
Acquired Contracts
2.079 In contrast to sets that do not have outputs, entities must evaluate acquired
contracts (when the set is receiving goods or services) to determine if the entity in effect
acquired an input or an organized workforce performing a substantive process. Paragraph
BC46 in the Basis for Conclusions of ASU 2017-01 states:
The Board concluded that the assessment of a contractual arrangement, such as a
supply agreement, should be relatively straightforward, meaning those contracts
would likely be inputs because the supplier is not applying a process to another
input in the set. However, the Board rejected the view that a service provided
through a contractual arrangement should never indicate that a substantive process
was acquired. The Board observed that there are many industries in which
operating activities are outsourced, and the activities performed by a service
provider may not be significantly different than the activities that would be
performed by employees. The Board acknowledges that in some circumstances,
whether an organized workforce accessed through a contractual arrangement
performs or provides a process could be subjective and the critical factor to
determining whether a set is a business.
2.080 Based on the Basis for Conclusions and as illustrated in Case F of ASU 2017-01
(ASC paragraphs 805-10-55-82 through 55-84), a typical supply agreement is an input.
However, when the vendor provides a service, the vendor could be applying a process to
an input for the set. For example, the service provider in an asset management contract
typically applies processes to the investment portfolio and customer contracts to raise and
deploy capital to create outputs. As a result, similar to employees, an acquired service
contract could be both an input and a process.
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2. Identifying a Business Combination
2.081 When the set includes a service contract, entities will need to make an evaluation
similar to evaluating an employee workforce to identify the processes that are performed
in the contract and whether that process (or group of processes) is critical to continue
producing outputs. However, we believe there should be more scrutiny applied to
conclude that an acquired service contract represents a substantive process when a set
does not include employees.
2.082 The inherent limitations of what may be performed by an acquired contract
requires an entity to analyze the substance of the acquired contract to determine if in
effect it has acquired an organized workforce. As a result, the guidance requires that
entities should also consider the duration and renewal terms of the acquired contract
when making this determination. The FASB did not provide additional guidance on how
to evaluate the duration or renewal options; however, we believe the objective is to
determine whether the entity acquired a substantive process (through the contract) or
whether the contract is in substance an input.
2.083 The nature of an acquired organized workforce is such that an entity obtains the
employees' knowledge and skills and therefore acquires a process that can be passed
along to other employees. As a result, the entity controls the process and can sustain it
even after termination of an individual employee. In contrast, if a service contract is not
renewed or was cancelled, the process may be terminated or need to be replaced. As a
result, if a contract has a long duration, the substance of the acquisition may be more akin
to acquiring an organized workforce and process that the entity effectively controls.
2.084 We believe that if the services contract is for a short duration (e.g., less than one
year with no explicit or implicit renewal options), generally the contract would not
provide an organized workforce performing a critical process. In contrast, a service
contract with a term greater than one year should be evaluated to determine whether the
process being performed is critical, similar to the evaluation for an employee workforce
(see Paragraphs 2.077 and 2.078). However, one year should not be viewed as a bright
line.
2.085 When considering short-term contracts with a renewal option (or long-term
contracts with termination provisions akin to a renewal), further consideration is needed.
The following factors may indicate that a service contract with renewal periods that
extend beyond one year is akin to acquiring an organized workforce:
• The services are proprietary or not easily accessible in the marketplace. If the
services are not readily available in the marketplace, it may indicate that the
acquired contract is a substantive process that is critical to continue producing
outputs; or
• Replacing the service provider would result in a significant cost, effort, or
delay in the ability to continue producing outputs.
2.086 However, if the services are provided only on a temporary basis, or if the services
are merely meant to help the acquirer transition on a temporary basis, that would indicate
that in substance the entity did not acquire an organized workforce that is critical to
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2. Identifying a Business Combination
continuing to produce outputs. This is different from acquiring an organized workforce
that has a going concern element (even if the entity planned to terminate the employees).
2.086a Because the assessment of whether the set is a business is made from the
perspective of a market participant, it is not relevant whether the acquirer plans on
terminating the contract.
Acquired Process Cannot Be Replaced without Significant Cost, Effort, or Delay or
Is Considered Unique or Scarce
2.087 An organized workforce is not required when outputs are present. The FASB
decided that an organized workforce might not be required if the set includes automated
processes (e.g., through acquired technology, infrastructure, or specialized equipment) or
other significant processes that significantly contribute to the ability to continue
producing outputs. As such, criteria (c) and (d) of ASC paragraph 805-10-55-5E address
the scenarios when a set would have a substantive process but no workforce. A
substantive process could also be present when the process would significantly contribute
to the ability to create outputs and either:
• The acquired process (or group of processes) cannot be replaced without
significant cost, effort, or delay in the ability to continue producing outputs; or
•
Is considered unique or scarce.
Examples include:
• A manufacturing process included in an assembly line that is highly
automated;
• A process embedded in the setup of the infrastructure that requires minimal
involvement from employees to complete;
• Proprietary production techniques; and
• Technology that performs processes to fulfill contracts with customers.
Revenue or Lease Contracts
2.088 While service contracts might provide access to an organized workforce
performing a substantive process, a revenue contract, lease arrangement (the acquiree is
the lessor), or other similar contracts should be excluded from the evaluation. ASC
paragraph 805-10-55-5F specifically requires an entity to exclude those contracts from
the evaluation of whether a substantive process is present. As a result, an entity would not
be able to conclude that it acquired a process solely because a revenue or lease contract
was present.
Presence of Goodwill
2.089 The presence of more than an insignificant amount of goodwill indicates that an
acquired process is substantive. However, the presence of goodwill does not always mean
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2. Identifying a Business Combination
a process is present. The entity should not assume that a process was acquired because
the set includes goodwill. Rather, the entity would first need to identify the acquired
process (and the organized workforce performing that process if the set does not have
outputs) and then it could use the presence of goodwill to help evaluate whether the
process is substantive.
2.090 One of the components of goodwill is usually the value of the assembled
workforce. As a result, fair value associated with a workforce may indicate that an
organized workforce is performing a critical process. Similarly, the excess of fair value
over the net assets acquired could also indicate that there is value in an acquired process
that would typically not be an identifiable asset.
2.091 Whether an entity records goodwill depends on the transaction being a business
combination. As a result, for purposes of this analysis (i.e., to determine if a transaction is
a business combination), the evaluation would focus on whether the consideration
transferred was in excess of the fair value of the identifiable net assets acquired.
Market Participant Concept
2.092 The evaluation of whether the acquired assets and activities constitute a business
should be based on whether the integrated set is capable of being conducted and managed
as a business by a market participant. It does not matter how the seller used, or acquirer
plans to use, the set when evaluating whether the set is a business.
2.092a For example, an entity may acquire a division from a seller of a vertically
integrated business. Because that set was operated by the seller, the division did not have
external customers; it only transferred goods to other divisions of the seller – e.g.
intercompany transfers. After the transaction, the former division would transfer the same
goods to its former parent although those sales would be recorded as revenue. When
viewing this set from the standpoint of a market participant, that set would have outputs
and the acquirer would need to evaluate whether both an input and substantive process
was acquired in accordance with ASC paragraph 805-10-55-5E.
2.093 Similarly, an entity might acquire a supplier even though the entity was that
supplier's only customer to more effectively manage its supply chain. It would not be
relevant how the acquirer intended to use the set when viewing the set from the
standpoint of a market participant. From the standpoint of a market participant, that set
would have outputs (even if post-transaction the goods or services are provided only to
internal divisions of the acquirer) and the acquirer would need to evaluate whether both
an input and substantive process was acquired in accordance with ASC paragraph 805-
10-55-5E.
2.094 The evaluation of whether ASC paragraphs 805-10-55-5D and 805-10-55-5E are
met should occur from a market participant's perspective. This may affect the conclusion
on whether a process is critical to the creation of outputs. A process that is not critical to
a specific acquiree that already has the same process in place may nevertheless be critical
to a market participant as that term is defined in ASC Topic 805.
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2. Identifying a Business Combination
2.094a For example, Company A acquires a set that includes processes to produce a
unique type of computer monitor that Company A already produces. Company A
acquired the set to take its competitor out of the market, because Company A and the
competitor are the only ones that currently produce the item. While the process to create
the unique computer monitor is not critical (or unique) to Company A, the process to
produce this item may be critical (or unique) to a market participant and must be
evaluated from that perspective when evaluating whether a business was acquired.
Example 2.14: Acquisition of Real Estate – Scenario 24
Facts
• REIT acquires 10 single-family homes, which have significant value in the
aggregate, in the Washington, D.C. metro area. The acquisition includes the
land, building, property improvements, and in-place leases.
• Each single-family home has a different layout (e.g., floor plan, square
footage, and design). The lessees are a similar class of customers.
• REIT also acquires an office park with six 10-story office buildings leased to
maximum occupancy, which have significant value in the aggregate.
• REIT acquires the vendor contracts for outsourced cleaning, security, and
maintenance.
• Seller’s employees that perform leasing (sales, underwriting, etc.), tenant
management, financing, and other strategic management processes are not
included in the set.
• No other assets are acquired in the transaction.
Analysis
Step 1 (Screening Test):
REIT chooses to perform the screening test qualitatively because it is clear that
substantially all of the fair value of the gross assets is not concentrated in a single asset or
group of similar assets. There is significant value in the 10 single-family homes and six
10-story office buildings.
The single-family homes and office buildings are in a different class of tangible assets,
and managing those assets (and producing outputs) has significantly different risks. Step
1 is not met.
Step 2 (Input and Substantive Process):
The set has outputs as a result of the continuing lease income from in-place leases on the
properties acquired. Accordingly, REIT considers the criteria in ASC paragraph 805-10-
55-5E.
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2. Identifying a Business Combination
The set does not include employees but does include acquired service contracts (e.g.,
contracts for outsourced cleaning, security, and maintenance). The acquired service
contracts are not substantive as the processes performed are not critical to continue
producing outputs (lease income). The functions of cleaning, security, and maintenance
do not generate substantive income in the real estate industry. These functions may be
substantive in other industries, but are not in the real estate industry.
In accordance with ASC paragraph 805-10-55-5F, the leases are excluded from the
analysis of whether a process was acquired. There is no substantive process acquired in
the set and Step 2 is not met.
Conclusion
The set does not include a substantive process and is therefore not a business.
Example 2.15: Acquisition of Loan Portfolio – Scenario 1 (continued)5
Facts
• Bank A acquires a portfolio of residential mortgages and a portfolio of
commercial mortgages, each having significant value and significantly
different risks (e.g., term, size, and risk ratings).
• Bank A does not acquire the employees that managed the credit risk of the
loan portfolios and had relationships with the borrowers in the acquisition.
Bank A does not acquire other protocols, conventions, or systems.
• The loan portfolios currently produce outputs (interest income).
Analysis
Step 1 (Screening Test):
As described in Example 2.10, the fair value of the gross assets is spread across the two
identifiable assets (loan portfolios); therefore, Step 1 is not met.
Step 2 (Input and Substantive Process):
The set has outputs as a result of the continuing interest income from the loans acquired.
Bank A evaluates the criteria in ASC paragraph 80-10-55-5E.
In accordance with ASC paragraph 805-10-55-5F, the loans are excluded from the
analysis of whether a process was acquired. The set does not include an organized
workforce or an acquired process. Step 2 is not met.
Conclusion
The set does not include a substantive process and is therefore not a business.
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2. Identifying a Business Combination
Example 2.16: Acquisition of Loan Portfolio – Scenario 26
Facts
• Bank A acquires from Bank Z a portfolio of residential mortgages and a
portfolio of commercial mortgages, each having significant value and
significantly different risks (e.g., term, size, and risk ratings).
• The set includes the employees of Bank Z that managed the credit risk of the
portfolio and the relationship with the borrowers (such as brokers and risk
managers).
• There is a more-than-insignificant amount of goodwill.
• The loan portfolios currently produce outputs (interest income).
Analysis
Step 1 (Screening Test):
Bank A concludes that substantially all of the fair value of the gross assets acquired is not
concentrated in a single or a group of similar identifiable asset(s). This is because the two
loan portfolios have significantly different risk characteristics and are not similar assets.
The fair value of the gross assets is spread across the two identifiable assets (loan
portfolios) because these assets are not similar for the purposes of applying the screening
test. Bank A also concludes that there is a more-than-insignificant amount of goodwill
associated with the acquired workforce, which affects the gross assets acquired (e.g., the
denominator). Step 1 is not met.
Step 2 (Input and Substantive Process):
The set has outputs as a result of the continuing interest income from the loans acquired.
Accordingly, Bank A evaluates the criteria in ASC paragraph 805-10-55-5E.
The set includes an organized workforce that performs processes (customer relationship
management and credit risk management) critical to the ability to continue producing
outputs. The fact that there is a more-than-insignificant amount of goodwill acquired
indicates the acquired workforce is performing a substantive process critical to continue
producing outputs. Step 2 is met.
Conclusion
The acquired set is a business because the set includes both an input and a substantive
process that together significantly contribute to the ability to continue producing outputs.
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2. Identifying a Business Combination
Example 2.17: Acquisition of Brands – Scenario 17
Facts
MSZ Corp. acquires
• The rights to Yogurt Brand F, including all related intellectual property;
• All customer contracts and relationships, finished goods inventory, marketing
materials, customer incentive programs, and raw material supply contracts;
and
• The specialized equipment specific to manufacturing Yogurt Brand F, and
documented processes and protocols to produce Yogurt Brand F.
MSZ Corp. does not acquire employees, manufacturing facilities, non-specialized
manufacturing equipment, and processes required to produce the product, and
distribution facilities (and related distribution processes).
There is a more-than-insignificant amount of goodwill.
The set currently produces outputs (Yogurt Brand F).
Analysis
Step 1 (Screening Test):
The gross assets include intellectual property (trademark, related trade name, and
recipes) associated with Yogurt Brand F, customer contracts and related relationships,
equipment, finished goods inventory, and the excess of the consideration transferred
over the fair value of the net assets acquired.
There is significant fair value in both tangible and intangible assets. MSZ Corp.
concludes that substantially all of the fair value of the gross assets acquired is not
concentrated in a single identifiable asset or group of similar identifiable assets even
though, for purposes of the analysis, the intellectual property is considered to be a single
identifiable asset. Step 1 is not met.
Step 2 (Input and Substantive Process):
As a part of Step 2, MSZ Corp. notes that the set has outputs through the continuation of
revenues. MSZ Corp. considers the criteria in ASC paragraph 805-10-55-5E. The set
does not include an organized workforce or an acquired contract that is in effect an
organized workforce. However, the acquired manufacturing processes are unique to
Yogurt Brand F, and when those processes are applied to acquired inputs such as the
intellectual property, raw material supply contracts, and the equipment, they
significantly contribute to the ability to continue producing outputs. The set includes
both inputs and substantive processes. Step 2 is met.
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2. Identifying a Business Combination
Conclusion
The acquired set is a business because the set includes inputs and substantive processes
that together significantly contribute to the ability to continue producing outputs.
Example 2.18: Acquisition of Oil and Gas Properties – Scenario 2
Facts
• XYZ Co. buys all the outstanding shares of Entity A, which owns and
operates a number of diverse oil and gas properties (both proved and unproved
properties).
• XYZ Co. acquires the employees and all of the assets including the long-lived
tangible assets of Entity A.
• There is significant fair value in the acquired workforce, production processes,
the oil and gas properties and other tangible assets.
• Entity A is currently generating revenues.
Analysis
Step 1 (Screening Test):
XYZ Co. first needs to determine whether Step 1 is met. XYZ Co. concludes that
substantially all of the fair value of the gross assets acquired is not concentrated in a
single or a group of similar identifiable assets.
This is because there is significant fair value in many different asset classes, including
intangible assets such as the acquired workforce and production processes (both of which
are included in goodwill for the screening test), and tangible assets including the oil and
gas properties (both proved and unproved properties), and other tangible assets. Step 1 is
not met.
Step 2 (Input and Substantive Process):
XYZ Co. notes that the acquired set has outputs and concludes that the employees make
up an organized workforce that has the necessary skills, knowledge or experience to
perform oil and gas processes. The oil and gas production processes cannot be replaced
without significant cost, effort or delay. Those processes are applied to the oil and gas
properties inputs and are critical to the ability to continue converting the inputs into
outputs.
There is also a more-than-insignificant amount of goodwill, which indicates the
workforce is performing a critical process. XYZ Co. concludes the set includes inputs
and substantive processes and is therefore a business. Step 2 is met.
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2. Identifying a Business Combination
Conclusion
The acquired set is a business because the set includes inputs and substantive processes
that together significantly contribute to the ability to create outputs.
Example 2.19: Acquisition of Properties That Are Simultaneously Leased to
Another Party
Facts
• Company A acquires 15 movie theater properties from Company B, an
independent third party.
• Company A simultaneously leases these theaters to Company C, also an
independent third party, under a triple-net master lease with a 20-year term.
• Company A will not operate the theaters. Company C acquires the operations
(theater management and other employees, ticketing systems, vendor
contracts, etc.) from Company B at the same time that it enters into the lease
with Company A and will operate the theaters.
• The 15 movie theaters vary in location, with different economic conditions,
market risks and local regulations. In addition, Company C will continue the
seller's practice of allowing the local management of each theater to select the
types of films to show based on the class of customer at each location. Films
range from new releases, classics, independent, documentary, etc.
• The fair values of the individual theaters vary; however, they are all within a
reasonable range with no significant outliers.
Analysis
Step 1 (Screening Test):
Company A concludes that substantially all of the fair value of the gross assets acquired
are not concentrated in a single or a group of similar identifiable assets. Company A notes
that the nature of the theaters' activities is similar. However, Company A concludes that
each theater property has significantly different risks associated with creating outputs
because of the different locations and classes of customers, and therefore they are not a
group of similar assets. The fair value of the gross assets acquired is spread across the
individual theaters.
Step 2 (Input and Substantive Process):
Company A concludes the set does not include a substantive process and is therefore not a
business. Company A notes that the acquired set has outputs and evaluates whether there
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2. Identifying a Business Combination
is an input and a substantive process using the criteria in paragraph 805-10-55-5E.
Company A acquired inputs (the 15 theater properties); however Company A did not
acquire processes. Rather, Company C acquired the theaters' processes directly from
Company B and will operate the theaters. Company A is not a party to that contract, and
therefore the processes transferred to Company C are not part of Company A's acquired
set.
Step 2 is not met.
Conclusion
The acquired set is not a business because the set does not include both an input and a
substantive process that together significantly contribute to the ability to create outputs.
APPLYING THE DEFINITION OF A BUSINESS TO FINANCIAL SERVICES
COMPANIES
2.095 Although the new framework applies equally across all industries, there are unique
aspects to applying the definition of a business to transactions involving financial
services companies due to the nature of their operations, which are often heavily cash
dependent and contain significant financial assets and liabilities. Transactions occurring
between financial services companies might also include few, if any, tangible assets.
Because cash and liabilities (such as customer deposits) are excluded from the screening
test, whether that test is met often will depend on the significance of loan or other
financial asset portfolios included in the set.
2.096 For instance, bank branch acquisitions may be accounted for as asset acquisitions
because the acquired set does not meet the definition of a business. The definition also
affects whether disposal transactions are in the scope of Topic 860 or Topic 810, which
could have meaningful implications for financial services companies.
Example 2.20: Acquisition of a Bank Branch
Facts
Bank A acquires a bank branch from Bank B. The branch consists primarily of savings
accounts, checking accounts, certificates of deposit, cash, and a small portfolio of
homogeneous consumer loans, as well as the physical premises (land, building, furniture,
and equipment). In the transaction, Bank A receives net cash from Bank B of
$27,030,000, consisting of $29,300,000 at the branch, less $2,270,000 consideration paid.
The bank branch serves as a location for customers to make deposits and loan payments
in-person and initiate new banking services.
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2. Identifying a Business Combination
Bank A identifies a core deposit intangible asset as part of the acquisition.
There is no goodwill associated with the set.
There are no marketing, strategic operations, loan or different product origination or
other back office operations within the bank branch as these functions were being
performed centrally at Bank B.
The branch managers and tellers become employees of Bank A on acquisition. The
employees could be replaced easily within the labor market.
The assets acquired and liabilities assumed would be recognized (under Topic 805) as
follows:
Cash
Loans
Furniture
Equipment
Building
Land
Core deposit intangible
Other liabilities
Deposit liabilities
Consideration paid
Analysis
Step 1 (Screening Test):
$29,300,000
$1,550,000
$30,000
$80,000
$200,000
$600,000
$350,000
$(40,000)
$(29,800,000)
$2,270,000
Bank A concludes that substantially all of the fair value is not concentrated in a single or
group of similar identifiable assets. The cash and liabilities are excluded from the
analysis in Step 1d under Topic 805. The analysis is as follows.
Step 1a
Bank A determines the identifiable assets that could be recognized separately in a
business combination. As shown above, the identifiable assets in the set include cash,
loans, furniture, equipment, building, land and the core deposit intangible.
Step 1b
Bank A evaluates whether any of the exceptions in paragraph 805-10-55-5B apply. Bank
A concludes that the building and land are a single asset because they are attached to and
cannot be physically removed from and used separately from each other without
incurring significant costs or reducing the fair value.
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2. Identifying a Business Combination
Step 1c
In applying paragraph 805-10-55-5C, Bank A notes that assets in different asset classes
are not similar assets. However, Bank A concludes that the loan portfolio consists of
loans that are similar assets. Additionally, Bank A concludes that all of the furniture are
similar assets, and all of the equipment are similar assets.
Step 1d
The gross assets acquired are as follows:
Items Acquired / Assumed Value under Topic 805
Included in Gross Assets
Cash
Loans
Furniture
Equipment
Building and land
Core deposit intangible
Other liabilities
Deposit liabilities
Total
$29,300,000
$1,550,000
$30,000
$80,000
$800,000
$350,000
$(40,000)
$(29,800,000)
$2,270,000
Not included
$1,550,000
$30,000
$80,000
$800,000
$350,000
Not included
Not included
$2,810,000
The fair value of gross assets acquired is $2,810,000 as the cash and liabilities are
excluded.
Step 1e
Bank A evaluates whether substantially all of the fair value is concentrated in a single
asset or group of similar assets.
The acquired asset with the greatest fair value is the loan portfolio. Its fair value of
$1,550,000 is compared to the gross assets acquired of $2,810,000, yielding 55%.
Step 1 is not met.
Step 2 (Input and Substantive Process):
The bank branch produces deposit fee revenue and interest income on loans, which are
considered outputs. Accordingly, Bank A considers the criteria in paragraph 805-10-55-
5E.
The set does not include an organized workforce that is critical to developing or
converting inputs into outputs, because:
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2. Identifying a Business Combination
• While the branch is dependent on its employees to conduct daily business, the
bank tellers and managers do not have specialized skills or knowledge
required to perform operational processes needed to continue producing
outputs based on the commonality in operating procedures across bank
branches and the fact that they can be easily replaced within the labor market.
• The branch employees help customers who want to take out a loan complete a
loan application, but they are not otherwise involved in the underwriting or
origination decision process.
• The employees do not perform strategic management or resource allocation
processes.
There are no acquired contracts that provide access to an organized workforce. The set
also does not include a process that cannot be replaced without significant cost, effort or
delay, or that is considered unique and scarce. Bank A could easily move the branch
servicing of the loan and deposit accounts acquired to other branches. The in-person
collection of customer deposits and loan payments is not proprietary or highly automated.
Conclusion
The acquired set is not a business because the set does not contain a substantive process.
Additional considerations
If substantially all of the fair value of the gross assets acquired had been concentrated in
a single or group of identifiable assets, e.g., the loan portfolio, Step 1 would have been
met and the set would not be a business. Step 2 would not have been required.
While the above example concludes that the acquired bank branch is not a business, there
may be circumstances in which acquired bank branches would be considered businesses.
These may include:
•
•
•
•
If the set includes autonomous banking operations with employees who
possess specialized skills or knowledge and who perform the strategic
functions necessary to generate outputs, which might be the case when
multiple bank branches are acquired, rather than one (e.g., a set that includes
all bank branches within a particular region that function independently from
other bank branches).
If the bank branch includes loan or other product origination operations and
relationship managers tasked with generating new business.
If there are strategic or marketing decisions made at the branch level.
If the acquired branch includes proprietary customer service operations (e.g.,
virtual teller technology) that are unique.
If there is a more than insignificant amount of goodwill in the set, that may indicate that
one or more substantive processes, such as the ones listed above, are present.
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The assessment of these factors would require additional analysis and judgment assessing
the individual facts and circumstances to determine whether the acquired branch(es) meet
the definition of a business.
2. Identifying a Business Combination
Example 2.21: Acquisition of an Asset Management Firm
Facts
ABC Corp., a diversified financial company, acquires an asset management entity that
provides investment advisory services to individuals in a stock deal valued at
$11,830,000.
The acquired set includes several asset managers and cash, land, building, furniture, and
equipment.
The acquired set also includes a contract with a third party for investment research
services priced at a market rate.
ABC identifies a large customer relationship intangible asset.
There is a more-than-insignificant amount of goodwill.
The acquisition is structured as a nontaxable stock acquisition and therefore the tax bases
of the asset management entity’s assets and liabilities carry over to ABC.
The set currently produces outputs (i.e., it provides asset management services and earns
fees).
The assets acquired and liabilities assumed would be recognized (under Topic 805) as
follows:
Cash
Furniture
Equipment
Acquired contract
Building
Land
Customer relationship intangible
Goodwill
Deferred income tax liabilities
Consideration paid
$60,000
$20,000
$50,000
$0
$750,000
$250,000
$5,700,000
$6,400,000
$(1,400,000)
$11,830,000
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2. Identifying a Business Combination
Analysis
Step 1 (Screening Test):
ABC concludes that substantially all of the fair value is not concentrated in a single or
group of similar identifiable assets. The analysis is as follows.
Step 1a
ABC determines the identifiable assets that could be recognized separately in a business
combination. As shown above, the identifiable assets in the set include cash, furniture,
equipment, an acquired contract, a building, land, a customer relationship intangible, and
goodwill. The acquired contract is priced at the current market rate and therefore has an
immaterial fair value (assumed to be $0 for this example).
Step 1b
ABC evaluates whether any of the exceptions in paragraph 805-10-55-5B apply. ABC
concludes that the building and land are a single asset because they are attached to and
cannot be physically removed from and used separately from each other without
incurring significant costs or reducing the fair value.
Step 1c
In applying paragraph 805-10-55-5C, ABC notes that assets in different asset classes are
not similar assets. ABC concludes that all of the furniture are similar assets, and all of the
equipment are similar assets.
Step 1d
In applying Step 1d, the gross assets acquired would not include the goodwill associated
with the deferred tax liabilities acquired in this transaction. The deferred tax liabilities
generate $1,400,000 of goodwill, which is excluded for purposes of applying Step 1,
leaving $5,000,000 of goodwill.
The gross assets acquired are as follows:
Items Acquired / Assumed Value under Topic 805
Included in Gross Assets
Cash
Furniture
Equipment
Acquired contract
Building and land
Customer relationship intangible
$60,000
$20,000
$50,000
$0
$1,000,000
$5,700,000
Not included
$20,000
$50,000
$0
$1,000,000
$5,700,000
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2. Identifying a Business Combination
Goodwill
Deferred income tax liabilities
Total
$6,400,000
$(1,400,000)
$11,830,000
$5,000,000
Not included
$11,770,000
The fair value of gross assets acquired is $11,770,000.
Step 1e
ABC evaluates whether substantially all of the fair value is concentrated in a single asset
or group of similar assets. The asset with the greatest fair value is the customer
relationship intangible asset. Its fair value of $5,700,000 is compared to the gross assets
acquired of $11,770,000, yielding 48%.
Step 1 is not met.
Step 2 (Input and Substantive Process):
The set has outputs as a result of the continued management fee income. Accordingly,
ABC evaluates the factors when a set has outputs.
The acquired set includes furniture, equipment, an acquired contract, land and building,
and a customer relationship intangible as inputs.
The set also includes an organized workforce that performs processes (investment
management) critical to the ability to continue producing outputs. ABC determined that
the asset managers included in the set have specialized skills and knowledge in providing
investment advice to clients. The asset managers are also directly involved in generating
new customers and producing revenue from existing clients. Therefore, ABC concludes
that the employees represent an organized workforce and Step 2 is met.
Conclusion
The acquired set is a business because the set includes inputs and substantive processes
that together significantly contribute to the ability to continue producing outputs.
Note that this fact pattern may be similar to other common financial services
transactions, such as the acquisition of an insurance agency or other service
organizations.
1 Based, in part, on Case H, Scenario 2, in ASU 2017-01.
2 Based, in part, on Case B, Scenario 2, in ASU 2017-01.
3 Based, in part, on Case C in ASU 2017-01.
4 Based, in part, on Case A, Scenario 2, in ASU 2017-01.
5 Based, in part, on Case H, Scenario 2, in ASU 2017-01.
6 Based, in part, on Case H, Scenario 3, in ASU 2017-01.
7 Based, in part, on Case G in ASU 2017-01.
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Section 3 - The Acquisition Method
OVERVIEW OF THE ACQUISITION METHOD
ASC paragraph 805-10-25-1
…An entity shall account for each business combination by applying the
acquisition method.
3.000 The definition of a business combination in the ASC Master Glossary includes
events and transactions in which an acquirer obtains control of one or more businesses,
regardless of how it obtains control. See the discussion of Business Combinations
Achieved without the Transfer of Consideration in Section 4.
3.001 Each transaction or other event that falls within the scope of ASC paragraphs 805-
10-15-3 and 15-4, as discussed in Section 1, is accounted for using the acquisition
method. If a transaction or event is outside the scope of ASC Topic 805, it is accounted
for based on other applicable GAAP.
ASC paragraph 805-10-05-4
…The acquisition method requires all of the following steps:
a. Identifying the acquirer
b. Determining the acquisition date
c. Recognizing and measuring the identifiable assets acquired, the liabilities
assumed, and any noncontrolling interest in the acquiree
d. Recognizing and measuring goodwill or a gain from a bargain purchase.
3.002 See the guidance in the following Sections for applying the acquisition method:
Identifying the Acquirer
a.
b. Determining the Acquisition Date
c. Recognizing and Measuring the Identifiable
Assets Acquired, the Liabilities Assumed, and
Any Noncontrolling Interest in the Acquiree
d. Recognizing and Measuring Goodwill or a Gain
Section 4
Section 5
Section 7
Section 8
from a Bargain Purchase
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Section 4 - Identifying the Acquirer
Detailed Contents
Acquirer (and Acquiree) Defined
Application of ASC Subtopic 810-10 Guidance to Identify the Acquirer
Consideration of Other Factors to Determine the Acquirer When Application of ASC
Subtopic 810-10 Guidance Does Not Clearly Identify the Acquirer
Combinations Effected Primarily by the Transfer of Cash or Other Assets, or Incurring
Liabilities
Capital Transactions versus Business Combinations
Combinations Effected Primarily by Exchanging Equity Interests
Example 4.0: Composition of Senior Management of the Combined Entity
Example 4.1: Voting Rights, Board of Directors, and Senior Management
Example 4.2: Voting Rights, Large Minority Interest, Board of Directors, and
Senior Management
Example 4.3: Voting Rights, Board of Directors, Senior Management, and
Payment of a Premium
Relative Size of the Combining Entities
Combinations Involving More Than Two Entities
Transactions Involving a Newly Formed Entity
Transactions Involving a Non-Substantive Newco
Example 4.3a: Transitory NewCo
Newly Formed Entity in an Exchange that Lacks Substance
Example 4.3b: Use of a NewCo in an Up-C Structure
Roll-Up Or Put-Together Transactions
Example 4.4: Roll-Up or Put-Together Transaction Involving Two Entities
Example 4.5: Roll-Up or Put-Together Transaction Involving More Than Two
Entities
Transactions Involving a Substantive Newco
Example 4.6: Newly Formed Entity Controlled by a Venture Capital Company
Example 4.6a: Newly Formed Entity Controlled by a Venture Capital Company
Special Purpose Acquisition Company (SPAC)
Business Combinations Achieved Without the Transfer of Consideration
Variable Interest Entities
Example 4.7: Initial Consolidation of a Variable Interest Entity
Business Combinations Achieved by Contract Alone Often Result in the Formation of
Variable Interest Entities
Reverse Acquisitions
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4. Identifying the Acquirer
ACQUIRER (AND ACQUIREE) DEFINED
ASC Master Glossary: Acquirer
The entity that obtains control of the acquiree. However, in a business
combination in which a variable interest entity (VIE) is acquired, the primary
beneficiary of that entity always is the acquirer.
ASC Master Glossary: Acquiree
The business or businesses that the acquirer obtains control of in a business
combination. This term also includes a nonprofit activity or business that a not-
for-profit acquirer obtains control of in an acquisition by a not-for-profit entity.
ASC paragraph 805-10-25-4
For each business combination, one of the combining entities shall be identified
as the acquirer.
ASC paragraph 805-10-25-5
The guidance in the General Subsections of [ASC] Subtopic 810-10 related to
determining the existence of a controlling financial interest shall be used to
identify the acquirer—the entity that obtains control of the acquiree. If a business
combination has occurred but applying the guidance does not clearly indicate
which of the combining entities is the acquirer, the factors in paragraphs 805-10-
55-11 through 55-15 shall be considered in making that determination. However,
in a business combination in which a variable interest entity (VIE) is acquired, the
primary beneficiary of that entity always is the acquirer. The determination of
which party, if any, is the primary beneficiary of a VIE shall be made in
accordance with the guidance in the Variable Interest Entities Subsections of
[ASC] Subtopic 810-10, not by applying either the guidance in the General
Subsections of that Subtopic, relating to a controlling financial interest, or in
[ASC] paragraphs 805-10-55-11 through 55-15.
(See discussions of Control and Business in Section 2.)
4.000 The acquirer in a business combination in which a variable interest entity is
acquired is always the primary beneficiary of the variable interest entity. See the
discussion of Variable Interest Entities beginning at Paragraph 4.025.
4.001 There is only one acquirer in every business combination, including combinations
of three or more entities. The acquirer is the entity that obtains control of a business (or
businesses). In business combinations involving more than two entities, determining the
acquirer includes consideration of, among other things, which of the combining entities
initiated the combination, as well as the relative size of the combining entities. See
discussion of Combinations Involving More Than Two Entities beginning at Paragraph
4.018.
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4. Identifying the Acquirer
APPLICATION OF ASC SUBTOPIC 810-10 GUIDANCE TO
IDENTIFY THE ACQUIRER
4.002 ASC Topic 805, Business Combinations, specifies that the guidance in ASC
Subtopic 810-10, Consolidation - Overall, should be used to determine the acquirer (i.e.,
the entity that obtains control of one or more businesses in a business combination), and
if applying that guidance does not clearly indicate which of the combining entities is the
acquirer, the factors in ASC paragraphs 805-10-55-11 through 55-15 should be
considered in making the determination.
4.003 ASC paragraph 810-10-15-8 specifies that the usual condition for obtaining control
is the ownership of more than 50% of the outstanding voting interest of another entity.
However, such ownership does not constitute control if it does not give the holder control
of the majority-owned entity. For example, as discussed in ASC paragraphs 810-10-25-1
through 25-14C, a minority shareholder or limited partner may have substantive
participating rights that prevent the majority holder from exercising control over the
investee. Conversely, an investor could obtain control over a business in situations where
the investor owns less than a majority (and perhaps none) of the voting interests in the
investee (e.g., in a situation where control is achieved by contract alone). See discussion
of Control beginning at Paragraph 2.004.
CONSIDERATION OF OTHER FACTORS TO DETERMINE THE
ACQUIRER WHEN APPLICATION OF ASC SUBTOPIC 810-10
GUIDANCE DOES NOT CLEARLY IDENTIFY THE ACQUIRER
4.004 If applying the guidance in ASC Subtopic 810-10 does not clearly indicate which
of the combining entities is the acquirer, ASC Topic 805 requires that other facts and
circumstances be considered in making the determination, including the factors described
in ASC paragraphs 805-10-55-11 through 55-15, discussed below. No individual factor is
necessarily determinative. Rather, all pertinent facts and circumstances should be
considered in determining which of the combining entities is the acquirer.
COMBINATIONS EFFECTED PRIMARILY BY THE TRANSFER OF CASH OR OTHER
ASSETS, OR INCURRING LIABILITIES
ASC paragraph 805-10-55-11
In a business combination effected primarily by transferring cash or other assets
or by incurring liabilities, the acquirer usually is the entity that transfers the cash
or other assets or incurs the liabilities.
4.005 In business combinations effected primarily by the transfer of cash, other assets, or
by incurring liabilities, the entity that transfers the cash or other assets, or incurs the
liabilities, is usually the acquirer. Regardless of the form of the transaction, if the acquirer
retains control of the transferred assets or liabilities (including an equity interest in a
subsidiary) after the business combination, it measures the transferred assets and
liabilities at their carrying amounts immediately before the acquisition date and does not
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4. Identifying the Acquirer
recognize a gain or loss on the transfer. See discussion and examples of Assets or
Liabilities Transferred by the Acquirer in Section 6.
Capital Transactions versus Business Combinations
4.006 The guidance in ASC paragraph 805-10-55-11 does not apply to a transaction that
in substance is a capital transaction rather than a business combination. In these
instances, the entity that distributes cash or assets is the acquiree and not the acquirer for
accounting purposes. The SEC staff, in the Division of Corporation Finance, Financial
Reporting Manual, par. 12100, states that the acquisition of a private operating company
by a nonoperating public shell company typically results in the owners and management
of the private company having actual or effective voting and operating control of the
combined company. This transaction is equivalent to the issuance of shares by the private
company for the net monetary assets of the shell company, accompanied by a
recapitalization (i.e., a reverse recapitalization). The accounting is similar to that for a
reverse acquisition; that is, the private company is the accounting acquirer (see Reverse
Acquisitions beginning at Paragraph 9.012), except that it recognizes no goodwill or other
intangible asset because the transaction does not constitute the acquisition of a business.
Similar to a reverse acquisition, the historical financial statements of the private operating
company (the accounting acquirer) are presented as the historical financial statements of
the combined entity in a reverse recapitalization. The equity of the private operating
company acquirer is presented as the equity of the combined entity; however, the share
capital account of the accounting acquirer is adjusted to reflect the par value of the
outstanding shares of the legal acquirer after considering shares issued in the transaction.
Earnings per share of the acquirer is restated for prior periods to reflect the changes in the
capital share account (see discussion of Preparation and presentation of consolidated
financial statements beginning at Paragraph 9.016).
4.007 Special considerations apply to transactions involving a newly formed entity. See
discussion at Paragraph 4.020a.
COMBINATIONS EFFECTED PRIMARILY BY EXCHANGING EQUITY INTERESTS
4.008 In most business combinations effected primarily through the exchange of equity
interests, the acquirer is the entity that issues the new equity interests. However, ASC
paragraphs 805-10-55-10 through 55-15 consider other pertinent facts and circumstances
in identifying the acquirer in such business combinations, including the factors described
in ASC paragraph 805-10-55-12. See discussion of Reverse Acquisitions beginning at
Paragraph 9.012, in which the issuing entity is the acquiree.
ASC paragraph 805-10-55-12
In a business combination effected primarily by exchanging equity interests, the
acquirer usually is the entity that issues its equity interests. However, in some
business combinations, commonly called reverse acquisitions, the issuing entity is
the acquiree. Subtopic 805-40 provides guidance on accounting for reverse
acquisitions. Other pertinent facts and circumstances also shall be considered in
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4. Identifying the Acquirer
identifying the acquirer in a business combination effected by exchanging equity
interests, including the following:
a. The relative voting rights in the combined entity after the business
combination. The acquirer usually is the combining entity whose owners as a
group retain or receive the largest portion of the voting rights in the combined
entity. In determining which group of owners retains or receives the largest
portion of the voting rights, an entity shall consider the existence of any
unusual or special voting arrangements and options, warrants, or convertible
securities...
4.009 The existence of equity interests, other than common shares, with voting rights
(e.g., voting preferred shares) may lead to identifying an acquirer other than the entity
that would have been identified in the absence of such equity interests. Options, warrants,
and convertible securities that are in-the-money and that are vested and exercisable or
convertible into shares with voting rights at the date of acquisition, including
exercisability or convertibility triggered by the terms of the acquisition, should also be
considered when determining relative voting rights.
4.010 In some transactions, voting rights of one or more classes of shares automatically
change at a future date or on the occurrence of specified events. For example, a class of
shares may be designated as nonvoting for the first year following the business
combination. All of the facts and circumstances of the transaction should be evaluated to
determine how this affects the identification of the acquirer. The factors described in
Paragraph 4.012 may be helpful in evaluating whether the period of time the shares are
nonvoting is substantive.
ASC subparagraph 805-10-55-12(b)
The existence of a large minority voting interest in the combined entity if no
other owner or organized group of owners has a significant voting interest.
The acquirer usually is the combining entity whose single owner or organized
group of owners holds the largest minority voting interest in the combined
entity.
4.011 This may be a significant factor in determining the acquirer for a put-together or
roll-up transaction. The application of this guidance is demonstrated in Examples 4.4,
4.5, and 4.6.
ASC subparagraph 805-10-55-12(c)
The composition of the governing body of the combined entity. The acquirer
usually is the combining entity whose owners have the ability to elect or
appoint or to remove a majority of the members of the governing body of the
combined entity.
4.012 ASC Topic 805 is silent as to whether the owner election rights need to exist only
at the acquisition date, or for a period of time thereafter. However, if control of the board
by a shareholder group is temporary, the control may not be substantive. In evaluating
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4. Identifying the Acquirer
this factor, consideration should be given not only to the board’s current composition, but
also to the period of time each board member is entitled to hold his or her board position,
taking into account scheduled board member retirements and scheduled elections after
the acquisition date. While there is no minimum duration required for a shareholder
group to be in control of the board for it to be deemed substantive, we believe that control
generally should extend for a sufficient duration to allow the board to consider and act on
significant substantive matters arising from the acquisition, such as those related to
corporate governance; the appointment and compensation of senior management; the
issuance of debt or equity securities; and substantive business integration, exit, and
disposal activities. Judgment is required in determining whether control of a shareholder
group following an acquisition is substantive. Although control for a period of two years
or more is generally sufficient to conclude that the control is substantive, an assessment
based on all the facts and circumstances should be made. In some cases, a period
exceeding two years might be required and, in other cases, a period of less than two years
may be substantive.
ASC subparagraph 805-10-55-12(d)
The composition of the senior management of the combined entity. The
acquirer usually is the combining entity whose former management dominates
the management of the combined entity.
4.013 Senior management generally consists of the executive chairman of the board, the
chief executive officer, the chief operating officer, the chief financial officer, divisional
heads, and members of the executive committee, if one exists. This description of senior
management is meant to identify functions, not necessarily managers with a specific title.
These functions should comprise the highest level of operating decision makers within
the combined entity. If the senior management of the combined entity is not dominated
by individuals from one of the combining entities, we believe that more weight should be
given to those executive positions that are most closely aligned with the core business
activities of the combined entity.
Example 4.0: Composition of Senior Management of the Combined Entity
ABC Corp. and DEF Corp. agree to merge their similarly sized pharmaceutical
businesses. ABC Corp. issues common shares to the shareholders of DEF Corp. in
exchange for all outstanding common shares of DEF. The shareholders of DEF will
receive 50.01% of the voting interests of the combined company.
The board of directors of the combined company will have four former ABC and four
former DEF directors. Staggered board elections will begin two years after
consummation of the business combination, and there are no scheduled board member
retirements before that time. Removal of board members requires a vote of at least two-
thirds of the shareholders. Management will consist of:
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4. Identifying the Acquirer
ABC
CEO
COO
Chief Medical Officer
DEF
President of Human Resources
General Counsel
CFO
No other relevant circumstances exist with respect to voting, ownership of significant
blocks of shares, etc.
Assessment
ABC will have the most influence in the combined company and is the acquirer.
Although the owners of DEF will receive a marginally larger portion of the voting rights
of the combined company, the senior management of ABC will assume the role of CEO
and other executive positions that are most closely aligned with the core business
activities of the combined entity (that is, development and marketing of pharmaceutical
products).
Considering the neutral status of the board of directors, the absence of board elections for
two years, the absence of significant blocks of voting rights, and the similar size of the
combining entities, the small voting majority of the owners of DEF does not represent a
decisive element of continuing control for DEF.
ASC subparagraph 805-10-55-12(e)
The terms of the exchange of equity interests. The acquirer usually is the
combining entity that pays a premium over the precombination fair value of
the equity interests of the other combining entity or entities.
4.014 The FASB did not provide any hierarchy for these factors. Some factors may be
more relevant to identifying the acquirer in one combination and less relevant in others.
Judgment is required in instances where the various factors individually point to different
entities as the acquirer.
4.015 Factors (a) through (d) relate to persons involved in controlling the operations of an
entity. These functions are sometimes collectively referred to as the governance system of
an entity. The premium mentioned in factor (e), referred to as a control premium1, can be
presumed to be paid because the members of the governance system of the paying entity
can extend their control to the acquirer.
4.016 The following examples assume that neither the guidance in ASC Subtopic 810-10,
nor any other factors clearly indicate which entity is the acquirer and, thus, the
determination of the acquirer is appropriately being made based on an analysis of the
factors in ASC paragraph 805-10-55-12.
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4. Identifying the Acquirer
Example 4.1: Voting Rights, Board of Directors, and Senior Management
ABC Corp. and DEF Corp. agree to merge their similar-sized businesses. ABC Corp.
issues common shares to the shareholders of DEF Corp. in exchange for all outstanding
common shares of DEF. The shareholders of DEF will receive 50.01% of the voting
interests of the combined company.
The board of directors of the combined company will have five former ABC and four
former DEF directors. Staggered board elections will begin two years after
consummation of the business combination, and there are no scheduled board member
retirements before that time. Removal of board members requires a vote of at least two-
thirds of the shareholders. Management will consist of:
ABC
Chairman/CEO
Co-COO*
CFO
DEF
President
Co-COO*
*ABC and DEF each have the right to appoint an individual that shares the COO position
with the Co-COO appointed by the other company.
No other relevant circumstances exist with respect to voting, ownership of significant
blocks of shares, management, etc.
Assessment
ABC is the acquirer. Although the owners of DEF will receive the larger portion of the
voting rights of the combined company, the members of the board of directors and senior
management of ABC will dominate the respective bodies of the combined company.
Considering the absence of significant blocks of voting rights, the absence of board
elections for two years, and the similar size of the combining entities, the small voting
majority of the owners of DEF does not represent a decisive element of continuing
control for DEF. Thus, ABC will have the most influence in the combined company for
at least two years after the business combination.
Example 4.2: Voting Rights, Large Minority Interest, Board of Directors, and
Senior Management
Bank A and Bank B agree to enter into a business combination. On consummation, Bank
A’s former shareholders will own 55% and Bank B’s former shareholders will own 45%
(30% of which will be owned by shareholder X) of the outstanding voting shares of the
combined entity. The largest former shareholder of Bank A will own 7% of the combined
entity.
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4. Identifying the Acquirer
As a condition of closing, shareholder X will be granted the right to appoint a majority of
the combined entity’s first board of directors (board members serve a three-year term).
The acquisition agreement also provides for the carryover of the CEO, CFO, and COO of
Bank B into comparable positions in the combined entity. The board of directors will
have the authority to appoint and remove the senior officers of the combined entity. No
other relevant circumstances exist with respect to voting, ownership of significant blocks
of shares, or management.
Assessment
Bank B is the acquirer. Despite the voting majority of the former shareholders of Bank A,
the significant minority interest of shareholder X and his or her right to appoint a
majority of the combined entity’s first board of directors (which will serve for three
years), together with the carryover of the senior management of Bank B indicate that
Bank B has the most influence in the combined entity.
Example 4.3: Voting Rights, Board of Directors, Senior Management, and
Payment of a Premium
ABC Corp. acquires 15% of the outstanding shares of a public company, DEF Corp., for
cash, paying a premium of 10% above the market price, and acquires the remaining
outstanding shares of DEF in exchange for shares of ABC. After the acquisition, the
former shareholders of DEF own 58% of the outstanding shares of the combined entity. If
exercised, warrants and convertible debentures held by former shareholders of DEF
would increase the interest of former shareholders of DEF to 71%; however, the warrants
and convertible debentures cannot be exercised for three years from the closing date.
The board of directors of the combined entity consists of five nominees of ABC and four
nominees of DEF for a two-year term. Removal of board members requires a vote of at
least two-thirds of the shareholders. The chairman and the CEO of ABC retain their
positions in the combined entity. No other relevant circumstances exist with respect to
voting, ownership of significant blocks of shares, or management.
Assessment
ABC has the most influence in the combined entity and is the acquirer. ABC paid partly
in cash, including a premium above market price, and dominates the board of directors
and senior management of the combined entity. DEF’s former shareholders will own the
majority of shares in the combined entity, but they will not own two-thirds of the shares
for at least three years following the business combination.
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4. Identifying the Acquirer
RELATIVE SIZE OF THE COMBINING ENTITIES
ASC paragraph 805-10-55-13
The acquirer usually is the combining entity whose relative size (measured in, for
example, assets, revenues, or earnings) is significantly larger than that of the other
combining entity or entities.
4.017 Judgment is required when comparing the combining entities based on their
relative size. When each combining entity is involved in similar activities and lines of
business, a comparison of relative size may be straightforward. For example, reported
revenues and total assets might be an appropriate comparison in these circumstances.
4.017a However, in circumstances where the combining entities are involved in disparate
activities and businesses, a comparison of relative size based on reported amounts might
not be appropriate, and information other than the reported amounts of assets, earnings,
and revenues may require consideration. Comparing the amount of reported revenues
without considering the nature and source of those revenues may not be meaningful. For
example, comparing revenues generated by an entity with high volume, high turnover,
and low gross margins (e.g., a grocery store chain) with revenues generated by an entity
with low volume, high value-added, and high gross margins (e.g., a custom designer and
manufacturer of specialized equipment) might not be meaningful.
4.017b Likewise, comparing the reported amount of total assets or net assets of an entity
whose principal revenue-generating assets are internally developed intangible assets (and
thus not reflected in the entity’s reported amounts) to the reported amount of total assets
or net assets of an entity whose principal revenue-generating assets are similar long-lived
intangible assets that were acquired in a series of business combinations (and thus are
reflected in the entity’s reported amounts) may not be particularly meaningful.
4.017c A comparison of operating cash flows might, in certain instances, be helpful in
identifying whether one of the combining entities is significantly larger than the other
combining entities. In certain instances, we believe that market capitalization may also be
an appropriate factor to consider in assessing the relative size of the combining entities.
COMBINATIONS INVOLVING MORE THAN TWO ENTITIES
ASC paragraph 805-10-55-14
In a business combination involving more than two entities, determining the
acquirer shall include a consideration of, among other things, which of the
combining entities initiated the combination, as well as the relative size of the
combining entities, as discussed in the preceding paragraph.
4.018 The definition of control could be viewed to exclude certain transactions in which
no former shareholder group obtains control of the combined entity, such as
combinations involving more than two entities, including roll-up and put-together
transactions. However, those transactions are business combinations under ASC Topic
805.
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4. Identifying the Acquirer
4.019 All of the factors in ASC paragraphs 805-10-55-11 through 55-15 require
consideration in identifying the acquirer if application of the guidance in ASC Subtopic
810-10 does not clearly identify the acquirer. The guidance in ASC paragraph 805-10-55-
12(b), which indicates that in combinations involving the exchange of equity interests,
the acquirer usually is the combining entity whose single owner or organized group of
owners holds the largest minority voting interest in the combined entity, may be
particularly helpful in identifying the acquirer in some combinations involving more than
two entities.
4.020 Example 4.5 illustrates an example of a business combination of more than two
entities.
TRANSACTIONS INVOLVING A NEWLY FORMED ENTITY
4.020a Special considerations apply when a new entity (NewCo) is formed to effect a
transaction. A newly formed entity with precombination activities deemed to be
significant (i.e., NewCo is substantive), but which do not constitute a business, can be the
acquirer in a business combination. That is, the accounting acquiree must be a business
for the transaction to be a business combination, but it is not necessary that the
accounting acquirer be a business. A nonsubstantive NewCo could indicate the
transaction is not a business combination or that another entity (e.g., one of the
combining entities) is the acquirer.
ASC paragraph 805-10-55-15
A new entity formed to effect a business combination is not necessarily the
acquirer. If a new entity is formed to issue equity interests to effect a business
combination, one of the combining entities that existed before the business
combination shall be identified as the acquirer by applying the guidance in [ASC]
paragraphs 805-10-55-10 through 55-14. In contrast, a new entity that transfers
cash or other assets or incurs liabilities as consideration may be the acquirer.
4.020b Factors to consider in determining whether the newly formed entity is substantive
include, but are not limited to:
• Whether the newly formed entity has assets other than cash related to the
initial equity investment made by its founder;
• Whether the newly formed entity survives the transaction;
• The precombination activities of the newly formed entity (e.g., raising capital,
issuing debt, identifying a target, negotiating, and promoting the business
combination);
• How long the newly formed entity has been in existence; and
• Whether the elements of the transaction are integrated or preconditioned on
each other.
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4. Identifying the Acquirer
Transactions Involving a Non-Substantive Newco
4.020c A transaction involving a newly formed entity with no significant pre-
combination activities may or may not be a business combination, depending on the facts
and circumstances.
Example 4.3a: Transitory NewCo
ABC forms NewCo to effect the acquisition of OpCo, which is a business. ABC
contributes cash into NewCo. NewCo immediately transfers the cash to Seller for 100%
of OpCo’s shares and merges with and into OpCo. OpCo is the surviving entity.
While NewCo transferred cash, NewCo is not substantive, and therefore cannot be the
accounting acquirer, because:
(1) NewCo was formed as a transitory entity only to effect the transaction;
(2) NewCo has no precombination activities; and
(3) NewCo does not survive.
ABC is the accounting acquirer and accounts for the acquisition of OpCo as a business
combination if it prepares consolidated financial statements. If OpCo prepares separate
financial statements, it can elect to apply pushdown accounting (see Section 27,
Application of Pushdown Accounting). If pushdown accounting is not applied, OpCo’s
assets and liabilities would remain at its historical cost basis.
Newly Formed Entity in an Exchange that Lacks Substance
4.020d If a newly formed entity with no significant precombination activities obtains a
controlling financial interest in an operating entity in a legal entity reorganization or an
exchange that lacks substance, the transaction would not be a business combination.
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Paragraph 6 of FASB Technical Bulletin No. 85-5, Issues Relating to Accounting for
Business Combinations, stated, “if the exchange lacks substance, it is not a purchase
event and should be accounted for based on existing carrying amounts.” Although FASB
Technical Bulletin No. 85-5 was superseded by Statement 141(R), we believe this
guidance remains relevant for transactions that lack economic substance (see also
Combinations Between Entities or Business with a High Degree of Common Ownership
beginning at Paragraph 28.009).
Example 4.3b: Use of a NewCo in an Up-C Structure
OpCo is an operating entity in the legal form of an LLC (a limited liability corporation)
with four Investors, one of whom holds a 40% interest (Investor A), and the remainder of
whom each holds a 20% interest (Investors B, C, and D). None of the Investors
individually controls OpCo. To effect an initial public offering of OpCo, Investor A
forms a corporation (NewCo) that will acquire OpCo and file a registration statement.
This is an example of a transaction commonly referred to as an "Up-C" structure.
Two steps are required to arrive at the desired structure. In Step 1, Investor A creates
NewCo and transfers all of its 40% interest in OpCo to NewCo. NewCo has no other
substantive assets or activities. After this step, the entities are organized as follows.
In Step 2, Investors B, C, and D each exchange their 20% interest in OpCo for a 20%
interest in NewCo. After the reorganization, the entities are structured as follows:
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4. Identifying the Acquirer
Assessment
NewCo's acquisition of OpCo is not a business combination. NewCo did not engage in
any significant precombination activities and did not raise any capital, identify
acquisition targets or negotiate transactions. Each Investor holds the same percentage
interest in NewCo as they held in OldCo before Step 1. Both Step 1 and Step 2 lack
economic substance and merely represent a change in the legal form to effect the IPO.
NewCo consolidates OpCo at the carryover basis of OpCo's assets and liabilities.
Roll-Up Or Put-Together Transactions
4.021 A transaction in which two or more entities transfer net assets that constitute a
business, or the owners of those entities transfer their equity interests to a newly formed
entity, is sometimes referred to as a roll-up or put-together transaction. These
transactions are business combinations and should be accounted for using the acquisition
method. If a new entity with no significant precombination activities is formed to issue
equity interests to effect a business combination, the newly formed entity should be
looked through, with one of the existing combining entities determined to be the acquirer.
Example 4.4: Roll-Up or Put-Together Transaction Involving Two Entities
ABC Corp. contributes its wholly owned subsidiary, Sub A, and DEF Corp. contributes
its wholly owned subsidiary, Sub D, to the newly formed XYZ Corp. In exchange, ABC
receives a 52% equity interest in XYZ and as a result has the ability to appoint a voting
majority of the board of directors of XYZ. DEF receives the remaining 48% equity
interest in XYZ. There are no other factors that indicate which of the combining entities
is the acquirer.
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4. Identifying the Acquirer
Assessment
At the XYZ level, Sub A is the acquirer. Newly formed XYZ had no significant
precombination activities and, thus, one of the combining entities must be identified as
the acquirer. Sub A’s parent (ABC) received a 52% equity interest in XYZ, and there are
no other factors that indicate which of the combining entities is the acquirer. XYZ should
account for this transaction using the acquisition method. Because Sub A is the acquirer,
its assets and liabilities should be recognized at their carryover basis, and the assets and
liabilities of Sub D should be recognized and measured under ASC Topic 805 (i.e., 100%
step-up to their acquisition-date fair values, subject to the exceptions to the recognition
and measurement principles of ASC Topic 805).
At the ABC consolidated level, it has effectively acquired a controlling financial interest
in Sub D (by acquiring a 52% equity interest in XYZ) in exchange for a noncontrolling
interest in Sub A (through the 48% noncontrolling interest in XYZ acquired by DEF).
Thus, in its consolidated financial statements, ABC should continue to recognize the
assets and liabilities of Sub A at their carryover basis, and account for the acquisition of
Sub D using the acquisition method. Therefore, ABC should recognize and measure the
assets and liabilities of Sub D under ASC Topic 805 (i.e., same basis as recognized and
measured in the consolidated financial statements of XYZ), and recognize the
noncontrolling interest in XYZ held by DEF at its acquisition-date fair value. ABC
recognizes no gain or loss on this transaction (unless there is a bargain purchase gain).
Example 4.5: Roll-Up or Put-Together Transaction Involving More Than Two
Entities
Companies A, B, C, and D each operate independent florist shops in suburbs of Metro
City (Metro). Company E operates four florist shops in Metro City. To capitalize on
economies of scale and other synergies, the owners agree to form a single entity (Metro
Florists, a voting interest entity) through a roll-up transaction. The ownership of Metro
Florists will be as follows: Companies A, B, and C shareholders – 15% each; Company D
shareholders – 20%; and Company E shareholders – 35%. There are no other factors that
indicate which entity is the acquirer.
Assessment
Newly formed Metro Florists had no significant precombination activities and, thus, one
of the combining entities must be identified as the acquirer. At the Metro Florists level,
Company E is the acquirer. Company E’s shareholders receive a greater interest in Metro
Florists (35%) than the shareholders of any of the other combining companies, and no
other factors indicate to the contrary. Metro Florists’ consolidated financial statements
will include the assets and liabilities of Company E at their carryover basis, and will
include the assets and liabilities of Companies A, B, C, and D, which are recognized and
measured under ASC Topic 805 (i.e., 100% step-up to their acquisition-date fair values,
subject to the exceptions to the recognition and measurement principles prescribed by
ASC Topic 805).
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4. Identifying the Acquirer
Transactions Involving a Substantive Newco
4.022 Although a new entity formed to effect a business combination is not necessarily
the acquirer, a newly formed entity that transfers cash or other assets or incurs liabilities
as consideration may be the acquirer. See Paragraph 4.020b for factors to consider in
determining whether the newly formed entity is substantive. If a newly formed entity is
substantive, further analysis of ASC Subtopic 810-10 and ASC paragraphs 805-10-55-11
through 55-15 (as discussed in 4.002 through 4.020a) will need to be performed to
determine if the newly formed entity is the acquirer. This situation could arise, for
example, in a roll-up transaction in which the number of shares in the combined entity
issued to new management and a sponsoring venture capital company exceeds the
number of shares issued to the former owners of the numerous combining companies
(refer to Example 4.6 for further discussion).
Example 4.6: Newly Formed Entity Controlled by a Venture Capital
Company
Assume the same facts as in Example 4.4, except that newly formed XYZ was formed by
a venture capital company, which transferred cash to XYZ in exchange for a 52% equity
interest in XYZ. ABC transferred Sub A to XYZ in exchange for a 25% interest in XYZ,
and DEF transferred Sub D to XYZ in exchange for a 23% interest in XYZ. Through its
52% equity interest, the venture capital company has the ability to appoint a voting
majority of the board of directors of XYZ. All other facts remain the same (i.e., there are
no other factors that indicate which of the combining entities is the acquirer).
Assessment
XYZ is the acquirer of Sub A and Sub D. Although XYZ is newly formed, a venture
capital company transferred cash to XYZ in exchange for a 52% equity interest in XYZ,
and has the ability to appoint a voting majority of the board of directors of Company
XYZ. XYZ should account for this transaction using the acquisition method, resulting in
the recognition and measurement of the assets and liabilities of both Sub A and Sub D
under ASC Topic 805 (i.e., 100% step-up to their acquisition-date fair values, subject to
the exceptions to the recognition and measurement principles prescribed by ASC Topic
805).
ABC, in its consolidated financial statements, will recognize a gain or loss on the
disposition of its controlling interest in Sub A equal to the difference between the
carrying value of that interest before the transaction and the fair value of the 25% interest
in XYZ received in the exchange. In the absence of evidence to the contrary, ABC and
DEF would be presumed to have the ability to exercise significant influence over XYZ
and would account for their respective investments in XYZ using the equity method of
accounting in accordance with ASC Topic 323, Investments—Equity Method and Joint
Ventures.
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4. Identifying the Acquirer
Example 4.6a: Newly Formed Entity Controlled by a Venture Capital
Company
A venture capital company forms a new company (XYZ) and transfers cash to XYZ in
exchange for a 100% equity interest in XYZ. Additionally, XYZ raises funds through a
debt offering and uses the proceeds and the cash received from the venture capital
company to acquire a controlling financial interest in ABC. XYZ survives the transaction
as the parent of ABC.
Assessment
XYZ is the acquirer. Although XYZ is newly formed, it raised funds independently
through the debt offering in addition to the cash contributions from the parent to
consummate the acquisition. As such, XYZ is considered to be substantive.
Special Purpose Acquisition Company (SPAC)
4.022a A SPAC is generally structured as a legal entity and often is funded through the
issuance of equity securities based on an agreement with its investors that the proceeds
will be used to acquire companies and/or assets within a predetermined period of time or
the unused proceeds will be returned to the investors. Management of the acquired
company is often retained to operate the business post-acquisition. SPACs'
precombination activities are to raise capital through an IPO, identify potential targets,
perform due diligence, and acquire one or more operating companies, usually within a
24-month period.
4.022b A SPAC generally has significant precombination activities associated with
executing its investment strategy. If the SPAC is the accounting acquirer and the
operating company is a business, the transaction would be accounted for as a business
combination. If the operating company is the accounting acquirer, the transaction
generally would be accounted for as a recapitalization consistent with the discussion in
Paragraph 4.006 because the SPAC likely would not meet the definition of a business,
assuming its primary asset is cash or marketable securities.
BUSINESS COMBINATIONS ACHIEVED WITHOUT THE
TRANSFER OF CONSIDERATION
4.023 Business combinations may occur without the transfer of consideration. For
example, an acquiree might repurchase a sufficient number of its own shares for an
existing investor to obtain control, minority veto rights that previously kept the holder of
a majority voting interest from controlling an investee might lapse, or control might be
achieved by contract alone. These transactions are business combinations, and the entity
that acquires control as a result is the acquirer.
4.024 Many business combinations achieved by contract alone result in the formation of a
variable interest entity (VIE). In these situations, the primary beneficiary of the VIE is
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4. Identifying the Acquirer
always the acquirer, because the acquiree’s equity-at-risk investors lack the power to
direct the activities that most significantly impact the VIE’s economic performance (as
described in ASC Subtopic 810-10). See the guidance immediately following, and
Business Combinations Achieved without the Transfer of Consideration, beginning at
Paragraph 9.003.
VARIABLE INTEREST ENTITIES
ASC paragraph 805-10-25-5
… However, in a business combination in which a variable interest entity (VIE) is
acquired, the primary beneficiary of that entity always is the acquirer. The
determination of which party, if any, is the primary beneficiary of a VIE shall be
made in accordance with the guidance in the Variable Interest Entities
Subsections of [ASC] Subtopic 810-10 not by applying either the guidance in the
General Subsections of that Subtopic, relating to a controlling financial interest,
or in [ASC] paragraphs 805-10-55-11 through 55-15.
4.025 As noted in ASC paragraph 810-10-15-14(b), if interests other than the equity
investment at risk provide the holders of those interests with the three characteristics in
ASC paragraph 810-10-15-14(b) or if interests other than the equity investment at risk
prevent the equity holders from having the characteristics in ASC paragraph 810-10-15-
14(b), the entity is a variable interest entity. In such situations, the primary beneficiary of
the VIE is always the acquirer. ASC Subtopic 810-10 requires a reporting entity to
determine whether it is the primary beneficiary of a VIE at the time the reporting entity
becomes involved with the VIE, and to reconsider that determination on a continuous
basis. ASC Subtopic 810-10 also includes guidance about when to reconsider whether an
entity in which a reporting entity holds a variable interest has become, or ceased to be, a
VIE.
4.026 ASC Subtopic 810-10 specifies that the initial consolidation of a variable interest
entity that is a business (as defined in the ASC Master Glossary) is a business
combination. Except for common control situations, as described below, and
circumstances where a new entity is formed and acquires an interest in a VIE in an
exchange that lacks substance (see Paragraph 4.020d), whenever a reporting entity
becomes the primary beneficiary of a VIE that is a business, even if the reporting entity
was previously involved with the VIE but was not the primary beneficiary, a business
combination has occurred and the acquisition method of accounting must be applied.
Upon initial consolidation by the primary beneficiary, the assets, liabilities, and
noncontrolling interests of a variable interest entity are recognized and measured at their
acquisition-date fair values, subject to the exceptions to the recognition and measurement
principles of ASC Topic 805. For situations in which a variable interest entity and its
primary beneficiary are under common control, see discussion in Paragraph 1.007. For
guidance on determining whether entities are under common control or have a high
degree of common ownership, see Section 28.
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4. Identifying the Acquirer
Example 4.7: Initial Consolidation of a Variable Interest Entity
Company A is involved with Entity B, a variable interest entity. Entity B is a business, as
defined in ASC Topic 805. In 20X7, at the time of Company A’s initial involvement with
Entity B, Company A determined that it was not the primary beneficiary of Entity B and,
accordingly, has not consolidated Entity B. However, on July 1, 20X9, the governing
documents and contractual arrangements among the parties involved with Entity B are
revised, such that the power to direct the activities that most significantly impact Entity
B’s economic performance is changed. As required by ASC Subtopic 810-10, Company
A continuously reassesses whether changes in facts and circumstances result in a change
in the determination of the primary beneficiary. As a result of the changes to the
governing documents and contractual arrangements, Company A determines that it is
now the primary beneficiary of Entity B.
This event is a business combination under ASC Topic 805 and, accordingly, at the
acquisition date (July 1, 20X9), Company A must apply the acquisition method to its
investment in Entity B, and include Entity B in its consolidated financial statements from
that date forward. Thus, as of July 1, 20X9, Company A:
(1) Remeasures its previously held interest in Entity B (using appropriate
valuation techniques – see Business Combinations Achieved without the
Transfer of Consideration in Section 9) at its acquisition-date fair value and
recognizes the resulting gain or loss, if any, in earnings;
(2) Recognizes and measures the full amount of the identified assets acquired, the
liabilities assumed, and the noncontrolling interest in Entity B under the
recognition and measurement principles of ASC Topic 805; and
(3) Recognizes and measures goodwill or a gain from a bargain purchase.
BUSINESS COMBINATIONS ACHIEVED BY CONTRACT ALONE OFTEN RESULT IN
THE FORMATION OF VARIABLE INTEREST ENTITIES
4.027 On February 18, 2015, the FASB issued ASU 2015-02, which changes the
evaluation of whether an entity has a controlling financial interest in an investee. The
guidance is effective for public business entities for annual and interim periods in fiscal
years beginning after December 15, 2015, and one year later for all other entities. Early
adoption is allowed, including early adoption in an interim period. The discussion
contained herein is based on the guidance in ASU 2015-02. In many business
combinations achieved by contract alone, the acquiree’s equity-at-risk investors would
lack at least one of the three characteristics in ASC paragraph 810-10-15-14(b) and the
acquiree would be a variable interest entity. Those characteristics include:
(1) The power, through voting rights or similar rights, to direct the activities of an
entity that most significantly impact the entity’s economic performance.
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4. Identifying the Acquirer
(i) For legal entities other than limited partnerships, if no owners hold voting
rights or similar rights (such as those of a common shareholder in a
corporation) over the activities of a legal entity that most significantly
affect the entity's economic performance, kick-out rights or participating
rights held by the holders of the equity investment at risk will not prevent
interests other than the equity investment from having this characteristic
unless a single party, or its related parties and de facto agents, has the
unilateral ability to exercise such rights.
(ii) For limited partnerships and similar entities, partners lack the power if a
simple majority or lower threshold of limited partners (including a single
limited partner) with equity at risk is not able to exercise substantive kick
out rights or participating rights through voting interests over the general
partner.
(2) The obligation to absorb the expected losses of the entity.
(3) The right to receive the expected residual returns of the entity.
4.028 In these situations, the primary beneficiary of the variable interest entity is always
the acquirer. See the discussion of A Business Combination Achieved by Contract Alone
beginning at Paragraph 9.008.
REVERSE ACQUISITIONS
4.029 In most business combinations effected through an exchange of equity interests, the
entity that issues the equity interests is usually the acquirer. However, in some business
combinations, referred to as reverse acquisitions, application of the guidance in ASC
paragraph 805-10-55-12 results in the identification of the legal acquirer (i.e., the entity
that issues the securities) as the accounting acquiree. In these situations, the transaction is
accounted for as a business combination only if the accounting acquiree meets the
definition of a business. See the discussion of Reverse Acquisitions beginning at
Paragraph 9.012.
1 Control premium may also be referred to as a Market Participant Acquisition Premium (MPAP).
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Section 5 - Determining the Acquisition
Date
Detailed Contents
Acquisition Date Defined
Acquisition Occurs when Control Is Obtained
Designation of an Effective Acquisition Date Other Than the Actual Acquisition Date
Is Not Permitted by ASC Topic 805
Step Acquisitions
Acquisitions of Noncontrolling Interests after Control Is Obtained
Acquisition Date Documentation
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5. Determining the Acquisition Date
ACQUISITION DATE DEFINED
ASC Paragraph 805-10-25-6
The acquirer shall identify the acquisition date, which is the date on which it
obtains control of the acquiree.
ASC Paragraph 805-10-25-7
The date on which the acquirer obtains control of the acquiree generally is the
date on which the acquirer legally transfers the consideration, acquires the assets,
and assumes the liabilities of the acquiree – the closing date. However, the
acquirer might obtain control on a date that is either earlier or later than the
closing date. For example, the acquisition date precedes the closing date if a
written agreement provides that the acquirer obtains control of the acquiree on a
date before the closing date. An acquirer shall consider all pertinent facts and
circumstances in identifying the acquisition date.
ACQUISITION OCCURS WHEN CONTROL IS OBTAINED
5.000 The acquisition date is the date on which the acquirer obtains control of the
acquiree, and the obtaining of control results in a business combination. Thus, on the
acquisition date, the acquirer accounts for the business combination by applying the
acquisition method.
5.001 The FASB concluded that to faithfully represent an acquirer’s financial position
and results of operations, the acquirer’s financial position should reflect the assets
acquired and liabilities assumed at the acquisition date – and not before or after they are
obtained or assumed, and that the acquirer’s financial statements should include only the
cash inflows and outflows, revenues and expenses, and other effects of the acquiree’s
operations after the acquisition date.
5.002 ASC Topic 805, Business Combinations, provides for the possibility that an
acquirer might obtain control of an acquiree on a date either earlier or later than the
closing date, indicating, for example, that the acquisition date precedes the closing date if
a written agreement enables the acquirer to control the acquiree on a date before the
closing date. However, situations where an acquirer obtains control of an acquiree on a
date before the closing date will be unusual, because control for this purpose means
control as defined and used in ASC Topic 810. See discussion of Control beginning at
Paragraph 2.004.
5.002a In certain instances, shareholder or regulatory approval is required to consummate
the business combination. Generally, the acquisition date does not precede the approval
date because the acquirer does not obtain control before approval. However, when the
only remaining contingency is shareholder approval, the acquisition date could precede
that approval if it is considered perfunctory and the acquirer controls the acquiree through
written agreement before the approval date. Shareholder approval would be perfunctory
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5. Determining the Acquisition Date
only if management and the board of directors control enough shareholder votes to
approve the transaction.
DESIGNATION OF AN EFFECTIVE ACQUISITION DATE OTHER THAN THE
ACTUAL ACQUISITION DATE IS NOT PERMITTED BY ASC TOPIC 805
5.003 Statement 141(R) (as codified by ASC Topic 805) eliminated the previous
provision in Statement 141 (the convenience exception) that allowed the acquirer in a
business combination, under certain circumstances, to designate an effective acquisition
date (i.e., the end of an accounting period between the dates a business combination was
initiated and consummated). Statement 141(R) also eliminated the previous provisions
that permitted an acquirer to include a subsidiary that was purchased during the year in
the acquirer’s consolidated financial statements as though the subsidiary had been
acquired at the beginning of the year and to deduct the preacquisition earnings of the
subsidiary at the bottom of the consolidated income statement.
5.004 The FASB noted that the financial statement effects of eliminating the convenience
exception are rarely likely to be material and that, unless events between the convenience
date and the actual acquisition date result in material differences in the amounts
recognized, an entity’s practice to designate a convenience date complies with the
requirements of ASC Topic 805 (see FASB Statement 141(R), Basis for Conclusions par.
B110 for detailed discussion). An acquirer can designate an acquisition date that precedes
the actual closing date under ASC Topic 805 only if it has determined that the effect of
this non-GAAP accounting policy on its financial statements is immaterial, both in the
period of the acquisition and in subsequent periods. Further, if a designated date is used
on the basis of its immateriality, the iron curtain method of assessing materiality
described in ASC paragraph 250-10-S99-2 requires the acquirer to have an unadjusted
difference that will carry forward for a significant period of time and, in many instances,
indefinitely.
STEP ACQUISITIONS
ASC Paragraph 805-10-25-9
An acquirer sometimes obtains control of an acquiree in which it held an equity
interest immediately before the acquisition date. For example, on December 31,
20X1, Entity A holds a 35 percent noncontrolling equity interest in Entity B. On
that date, Entity A purchases an additional 40 percent interest in Entity B, which
gives it control of Entity B. This Topic refers to such a transaction as a business
combination achieved in stages, sometimes also referred to as a step acquisition.
ASC Paragraph 805-10-25-10
In a business combination achieved in stages, the acquirer shall remeasure its
previously held equity interest in the acquiree at its acquisition-date fair value and
recognize the resulting gain or loss, if any, in earnings. In prior reporting periods,
with respect to its previously held equity method investment, the acquirer may
have recognized amounts in other comprehensive income in accordance with
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5. Determining the Acquisition Date
paragraph 323-10-35-18. If so, the amount that was recognized in other
comprehensive income shall be reclassified and included in the calculation of gain
or loss as of the acquisition date. If the business combination achieved in stages
relates to a previously held equity method investment that is a foreign entity, the
amount of accumulated other comprehensive income that is reclassified and
included in the calculation of gain or loss shall include any foreign currency
translation adjustment related to that previously held investment. For guidance on
derecognizing foreign currency translation adjustments recorded in accumulated
other comprehensive income, see Section 830-30-40.
5.005 A business combination occurs whenever an entity obtains control over one or
more businesses. In a step acquisition, an entity (the acquirer) acquires shares of another
entity (the investee) in two or more transactions in which the acquirer ultimately gains
control of the investee. On the date the acquirer obtains control over the acquiree, a
business combination has occurred, and the acquirer accounts for the combination by the
acquisition method on that date.
5.006 Acquisition by a parent of some or all of a noncontrolling interest in a subsidiary
(that is a business) after it initially gains control is not a business combination, because
control is not obtained as a result of this transaction (i.e., the parent had control over the
subsidiary before the transaction). A business combination occurs only on the acquisition
date (i.e., when control is obtained). See Appendix 4-1 in KPMG Guide To Accounting
For Foreign Currency, for guidance on accounting for foreign currency translation
adjustments in business combinations of foreign equity method investments achieved in
stages.
ACQUISITIONS OF NONCONTROLLING INTERESTS AFTER CONTROL IS
OBTAINED
5.007 Changes in the parent’s ownership interest, as long as it continues to retain control,
are accounted for as equity transactions (investments by owners and distributions to
owners acting in their capacity as owners) under ASC Subtopic 810-10. Thus, no gains or
losses with respect to these changes are recognized in net income or comprehensive
income, nor are the carrying amounts of the assets and liabilities of the subsidiary
adjusted (i.e., step acquisition accounting is not applied). Rather, the parent adjusts the
carrying amount of the noncontrolling interest to reflect the change in its ownership
interest in the subsidiary. See KPMG Handbook, Consolidation, for further discussion.
See discussion of Business Combinations Achieved in Stages (Step Acquisitions) in
Section 9.
ACQUISITION DATE DOCUMENTATION
5.008 ASC Topic 350, Intangibles -- Goodwill and Other, requires that the assets
acquired and liabilities assumed in a business combination, including goodwill, be
assigned to reporting units as of the acquisition date. ASC Topic 350 also requires that
the basis for and method of determining the fair value of the acquiree and other related
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factors (such as the underlying reasons for the acquisition and management’s
expectations related to dilution, synergies, and other financial measurements) be
documented at the acquisition date. ASC paragraph 350-20-35-40
5. Determining the Acquisition Date
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Section 6 - Recognizing and Measuring
the Consideration Transferred
Detailed Contents
Consideration Transferred Includes only the Consideration Exchanged by the Acquirer
for the Acquiree
Consideration Transferred Is not Eligible for Hedge Accounting
Measurement of the Consideration Transferred
Consideration in the Form of Equity Interests
Issuing Shares of a Nonpublic or Closely Held Entity
Preferred Shares Issued in a Business Combination
Convertible Preferred Shares and Other Convertible Instruments Issued in a
Business Combination
Liabilities Incurred to Former Owners of the Acquiree
Contingent Consideration
Assets or Liabilities Transferred by the Acquirer
Example 6.1: Consideration Includes a Cost Method Investment
Example 6.2: Consideration Includes a Technology License
Assets or Liabilities Transferred to an Acquiree That Remain Under the Control
of the Acquirer Are Not Remeasured, and No Gain Or Loss Is Recognized
Example 6.3: Transfer of a Subsidiary to an Acquiree
Example 6.4: Shares of a Subsidiary Issued in a Business Combination
Example 6.5: Acquisition Achieved in Stages Through the Exchange of an
Indirect Noncontrolling Interest in a Subsidiary, Including Payment of a Control
Premium
Share-Based Payment Awards Included in the Consideration Transferred
Contingent Consideration
Working Capital
Consideration Held in Escrow for general Representations and Warranties
Forms of Contingent Consideration
Initial Recognition of Contingent Consideration
Statement of Cash Flows
Determining the Classification of Contingent Consideration
Example 6.6: Cash-Settled Contingent Consideration Based on Earnings
Classification of Equity-Linked Contingent Consideration Arrangements That
Are Within the Scope of ASC Subtopic 480-10
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6. Recognizing and Measuring the Consideration Transferred
Illustrations of Contingent Consideration Arrangements That Are Classified as
Liabilities Under ASC Subtopic 480-10
Example 6.7: Contingent Consideration That Embodies a Written Put Option
Example 6.8: Contingent Consideration That Embodies a Guarantee of the
Acquirer’s Share Price
Example 6.9: Contingent Consideration in the Form of a Freestanding Financial
Instrument
Example 6.10: Contingent Consideration Based on Earnings
Example 6.11: Fixed Minimum Payment and Contingent Consideration Based on
Earnings
Classification of Equity-Linked Contingent Consideration Arrangements That
Are Not Within the Scope of ASC Subtopic 480-10
Example 6.12: Contingent Consideration That Provides for Different Outcomes
Involving the Issuance of Shares That Are Based on the Level of Revenues
Achieved
Example 6.13: Reclassification of a Contingent Consideration Arrangement from
Equity to a Liability
Example 6.14:Reclassification of a Contingent Consideration Arrangement from a
Liability to Equity
Example 6.15: Contingent Consideration That Embodies a Net-Share Settled
Written Call Option
Example 6.16: Contingent Consideration That Provides for the Issuance of a
Fixed Number of Shares Payable on the Achievement of an Earnings Target
Example 6.17: Fixed Minimum Number of Shares and Contingent Consideration
That Provides for the Issuance of a Fixed Number of Additional Shares Payable
on the Achievement of an Earnings Target
Example 6.18: Contingent Consideration Based on the Acquirer’s Stock Price
Determining the Unit(s) of Accounting for Contingent Consideration
Example 6.19: Determining the Unit(s) of Accounting for Contingent
Consideration – Scenario 1
Example 6.20: Determining the Unit(s) of Accounting for Contingent
Consideration – Scenario 2
Subsequent Issuance of Contingent Shares Based on Earnings in a Reverse Acquisition
Effect of Contingent Consideration on the Computation of Earnings Per Share
Effect of Contingency Based on Security Prices in Computing Earnings Per Share
Effect of Contingency Based on Both Future Earnings and Security Prices in
Computing Earnings Per Share
Business Combinations in Which no Consideration Is Transferred
Measurement of Consideration Transferred in Combinations Involving Mutual Entities
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6. Recognizing and Measuring the Consideration Transferred
CONSIDERATION TRANSFERRED INCLUDES ONLY THE
CONSIDERATION EXCHANGED BY THE ACQUIRER FOR THE
ACQUIREE
ASC Paragraph 805-10-25-20
The acquirer and the acquiree may have a preexisting relationship or other
arrangement before negotiations for the business combination began, or they may
enter into an arrangement during the negotiations that is separate from the
business combination. In either situation, the acquirer shall identify any amounts
that are not part of what the acquirer and the acquiree (or its former owners)
exchanged in the business combination, that is, amounts that are not part of the
exchange for the acquiree. The acquirer shall recognize as part of applying the
acquisition method only the consideration transferred for the acquiree and the
assets acquired and liabilities assumed in the exchange for the acquiree. Separate
transactions shall be accounted for in accordance with the relevant generally
accepted accounting principles (GAAP).
ASC Paragraph 805-10-25-21
A transaction entered into by or on behalf of the acquirer or primarily for the
benefit of the acquirer or the combined entity, rather than primarily for the benefit
of the acquiree (or its former owners) before the combination, is likely to be a
separate transaction. The following are examples of separate transactions that are
not to be included in applying the acquisition method:
a. A transaction that in effect settles preexisting relationships between the
acquirer and acquiree (see [ASC] paragraphs 805-10-55-20 through 55-23)
b. A transaction that compensates employees or former owners of the acquiree
for future services (see [ASC] paragraphs 805-10-55-24 through 55-26)
c. A transaction that reimburses the acquiree or its former owners for paying
the acquirer’s acquisition-related costs (see [ASC] paragraph 805-10-25-23).
6.000 ASC Topic 805, Business Combinations, requires an acquirer to identify any
amounts that are not part of what the acquirer and the acquiree (or its former owners)
exchanged in the business combination. The acquiree accounts for separate transactions
that do not represent consideration transferred for the acquiree in accordance with other
relevant GAAP. Only the consideration transferred for the acquiree is included as
consideration transferred in applying the acquisition method.
6.001 Amounts related to the settlement of preexisting relationships between an acquirer
and an acquiree, a transaction that compensates employees or former owners of the
acquiree for future services, and a transaction that reimburses the acquiree or its former
owners for paying the acquirer’s acquisition-related costs, are examples of transactions
that are not included in applying the acquisition method, but rather are accounted for as
separate transactions in accordance with relevant GAAP. See Determining What Is Part
of the Business Combination Transaction in Section 11.
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6. Recognizing and Measuring the Consideration Transferred
CONSIDERATION TRANSFERRED IS NOT ELIGIBLE FOR
HEDGE ACCOUNTING
6.002 The measurement of the consideration transferred in a business combination is not
affected by gains and losses from derivative or nonderivative financial instruments. A
firm commitment to enter into a business combination is not eligible for designation as a
hedged item in a fair value hedge. (ASC paragraph 815-20-25-43(c)(5)) In addition, a
forecasted transaction (for which there is no firm commitment) that involves a business
combination is not eligible for designation as a hedged transaction in a cash flow hedge.
(ASC paragraph 815-20-25-15(g)) Thus, the costs and proceeds (including gains and
losses) from financial instruments that are used to reduce the risks of a change in the
value of the acquiree’s net assets or the consideration to be issued by the acquirer before
the date of acquisition are not part of the consideration transferred and should be recorded
currently in earnings.
MEASUREMENT OF THE CONSIDERATION TRANSFERRED
ASC Paragraph 805-30-30-7
The consideration transferred in a business combination shall be measured at fair
value, which shall be calculated as the sum of the acquisition-date fair values of
the assets transferred by the acquirer, the liabilities incurred by the acquirer to
former owners of the acquiree, and the equity interests issued by the acquirer.
(However, any portion of the acquirer’s share-based payment awards exchanged
for awards held by the acquiree’s grantees that is included in consideration
transferred in the business combination shall be measured in accordance with
[ASC] paragraph 805-20-30-21 rather than at fair value.) Examples of potential
forms of consideration include the following:
a. Cash
b. Other assets
c. A business or a subsidiary of the acquirer
d. Contingent consideration (see [ASC] paragraphs 805-30-25-5 through 25-7)
e. Common or preferred equity instruments
f. Options
g. Warrants
h. Member interests of mutual entities.
6.003 Consideration may be issued in many forms and may include, for example, cash,
noncash assets (such as a business or a subsidiary), debt issued to the former owners of
the acquiree, equity interests issued (such as common or preferred equity instruments,
options, warrants, or member interests of mutual entities), the portion of any share-based
payment awards required to be issued by an acquirer to replace awards held by grantees
of the acquiree (replacement awards) included in the consideration transferred, and
contingent consideration. The consideration transferred in a business combination is
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6. Recognizing and Measuring the Consideration Transferred
measured at fair value, determined in accordance with ASC Topic 820, Fair Value
Measurement, except for (i) assets and liabilities transferred that remain under the control
of the acquiree after the business combination, and (ii) any portion of the acquirer’s
share-based replacement awards exchanged for awards held by the acquiree’s grantees
included in the consideration transferred, and is the sum of the following:
• The acquisition-date fair value of the equity interests issued by the acquirer
(other than share-based payment awards included in the consideration
transferred);
• The acquisition-date fair value of the liabilities incurred by the acquirer to
former owners of the acquiree;
• The acquisition-date fair value of the assets transferred by the acquirer;
• The amount of the liability or equity instruments related to share-based
replacement awards required to be issued by an acquirer and included in the
consideration transferred, measured in accordance with ASC Topic 718,
Compensation—Stock Compensation. ASC paragraph 805-20-30-21 refers to
the results of amounts measured in this manner as the fair-value-based
measure of the awards; and
• The acquisition-date fair value of contingent consideration issued by the
acquirer.
6.004 Cash payments by an acquirer do not present measurement difficulties. However,
the measurement of other forms of consideration can present varying degrees of difficulty
and require judgment, and it may be necessary to obtain independent valuations of the
consideration exchanged in some situations. This Section addresses measuring the
consideration transferred in a business combination. See Section 18, Determining the
Fair Value of the Consideration Transferred in a Business Combination, for additional
discussion.
CONSIDERATION IN THE FORM OF EQUITY INTERESTS
6.005 Equity interests issued as consideration in a business combination (other than
share-based replacement awards) are measured at fair value at the acquisition date,
determined in accordance with ASC Topic 820. Whenever available, the quoted price in
an active market should be used to measure the fair value of equity securities issued to
effect a business combination. If a quoted price in an active market is not available, other
methods or techniques should be used.
Issuing Shares of a Nonpublic or Closely Held Entity
ASC Paragraph 805-30-30-2
In a business combination in which the acquirer and the acquiree (or its former
owners) exchange only equity interests, the acquisition-date fair value of the
acquiree’s equity interests may be more reliably measurable than the acquisition-
date fair value of the acquirer’s equity interests. If so, the acquirer shall determine
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6. Recognizing and Measuring the Consideration Transferred
the amount of goodwill by using the acquisition-date fair value of the acquiree’s
equity interests instead of the acquisition-date fair value of the equity interests
transferred.
6.006 The acquisition of a public entity by a nonpublic or closely held entity provides an
example of where the acquisition-date fair value of an acquiree’s equity interests may be
more reliably measurable than the acquisition-date fair value of the acquirer’s equity
interests issued to effect a business combination. In those situations, a nonpublic acquirer
may look to the fair value of the acquiree’s equity interests in determining the fair value
of the shares issued to effect the combination.
Preferred Shares Issued in a Business Combination
6.007 When preferred shares are issued in a business combination to the shareholders of
the acquiree and there is no quoted market price available to determine the fair value of
those shares, the characteristics of the preferred shares (e.g., dividend rate, conversion
features, or redemption features) should be incorporated into the fair value of the
preferred shares. For example, the fair value of nonvoting, nonconvertible preferred
shares that lack characteristics of common shares may be determined by comparing the
specified dividend and redemption terms with those of comparable securities and by
assessing market factors. Thus, the approach to determining the fair value of such shares
may be similar to that used to determine the fair value of debt securities.
Convertible Preferred Shares and Other Convertible Instruments Issued in a
Business Combination
6.008 If there is no quoted market price available to determine the fair value of
convertible preferred shares or other convertible instruments issued in a business
combination, the acquirer should refer to other guidance to determine the fair value of the
instruments, consistent with ASC Topic 820. Consideration of the guidance in ASC
paragraphs 470-20-30-22 through 30-26 may be helpful in determining the fair value of
convertible instruments. That guidance indicates that recent issuances of similar
convertible instruments for cash to parties that have only a creditor/investor relationship
with the issuer may provide the best evidence of fair value of the convertible instruments.
The fair value of the convertible instruments will not be less than the fair value of the
equity shares into which they can currently be converted. Thus, a currently effective
conversion option could not be a beneficial conversion feature (i.e., there would be no
intrinsic value) at the acquisition date.
6.009 The entity must consider the conversion feature of any convertible instruments
issued as consideration in a business combination. If the conversion feature is in-the-
money at the acquisition date (beneficial conversion feature), the acquirer should follow
the guidance in ASC paragraphs 470-20-25-4 through 25-9 and 30-3 through 30-8.
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6. Recognizing and Measuring the Consideration Transferred
LIABILITIES INCURRED TO FORMER OWNERS OF THE ACQUIREE
6.010 Liabilities that an acquirer incurs to former owners of an acquiree are part of the
consideration transferred. These liabilities include amounts payable to dissenting
shareholders. For guidance on presenting payments to former owners to settle those
liabilities in the statement of cash flows, see chapter 18 of KPMG Handbook, Statement
of cash flows.
CONTINGENT CONSIDERATION
6.011 Contingent consideration includes obligations to transfer additional consideration
to the former owners of an acquiree if future events occur or conditions are met.
Obligations of an acquirer under contingent consideration arrangements may be classified
as equity (equity-classified contingent consideration) or a liability (liability-classified
contingent consideration). See discussion beginning at Paragraph 6.019.
• Obligations to pay specified amounts at specified future dates are recognized
and measured at fair value at the acquisition date and included in the
consideration transferred. They are noncontingent obligations and thus are not
subsequently remeasured.
• Equity-classified contingent consideration is recognized and measured at fair
value at the acquisition date and included in the consideration transferred.
Equity-classified contingent consideration is not remeasured following the
acquisition date, and its subsequent settlement is accounted for within equity.
• Liability-classified contingent consideration is recognized and measured at
fair value at the acquisition date and included in the consideration transferred,
and subsequently remeasured to fair value each reporting period until the
contingency is resolved. Adjustments resulting from remeasurement are
recognized in earnings (unless the contingent consideration is a hedging
instrument).
6.012 The nature of the arrangements determines whether payments to employees or
selling shareholders are contingent consideration in the business combination or are
separate transactions. See Transactions That Compensate Employees or Former Owners
of the Acquiree for Future Services in Section 11.
6.013 In some business combinations, there may be a preexisting arrangement between
the acquirer and acquiree that provides for a payment when a contingent event occurs.
For example, the acquirer and acquiree could have a preexisting agreement that granted
the acquirer distribution rights to the acquiree's products in a geographic region with
payments by the acquirer to the acquiree depending on the sales made in that geographic
region. In negotiating the acquisition agreement, if the two parties agree to carry forward
the preexisting agreement without change, the payments contingently payable to the
former owner of the acquiree under that agreement would be treated as contingent
consideration in the acquisition, because the future payment was contemplated in the
acquisition negotiations. In effect, the acquisition negotiations change the contingent
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6. Recognizing and Measuring the Consideration Transferred
payments from a contingent liability (preacquisition) to contingent consideration in the
acquisition.
6.013a However, a new arrangement entered into in conjunction with a business
combination may require future payments from the acquirer to the former owner of the
acquiree with characteristics of both contingent consideration and compensation for
future rights granted or services provided by the former owner to the acquirer or
combined entity. The acquirer should carefully evaluate these arrangements when
determining whether the future payments should be included as consideration transferred
in applying the acquisition method or accounted for separately under other GAAP. For
example, a buyer and seller may negotiate contingent consideration in the form of an
earnout based on revenue or profits as part of the transaction price when they cannot
agree on the transaction price. Conversely, the buyer and seller of a distribution business
may enter a new arrangement that includes a long-term, non-cancelable sales or earnings-
based royalty payment to the seller for the buyer’s future use of a trademark or
distribution within a geographic area. The royalty payments are customary in the seller’s
industry and set at market rates. In this case, the royalty arrangement is not contingent
consideration in the business combination and is accounted for separately as an expense
in the period(s) payments are accruable. In addition to the factors discussed in Section 11,
Determining What Is Part of the Business Combination Transaction, the following
factors indicate that these future payments are not part of consideration transferred in a
business combination:
• The payments are customary in the industry and set at market rates;
• The payment period coincides with the duration of the future services to be
provided or rights granted by the former owner of the acquiree;
• The royalty or similar arrangement did not exist before the business
combination;
• The resulting consideration transferred in the business combination (excluding
the fair value of the future payments) is reasonable relative to the valuation of
the business acquired.
ASSETS OR LIABILITIES TRANSFERRED BY THE ACQUIRER
ASC Paragraph 805-30-30-8
The consideration transferred may include assets or liabilities of the acquirer that
have carrying amounts that differ from their fair values at the acquisition date (for
example, nonmonetary assets or a business of the acquirer). If so, the acquirer
shall remeasure the transferred assets or liabilities to their fair values as of the
acquisition date and recognize the resulting gains or losses, if any, in earnings.
However, sometimes the transferred assets or liabilities remain within the
combined entity after the business combination (for example, because the assets
or liabilities were transferred to the acquiree rather than to its former owners), and
the acquirer therefore retains control of them. In that situation, the acquirer shall
measure those assets and liabilities at their carrying amounts immediately before
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6. Recognizing and Measuring the Consideration Transferred
the acquisition date and shall not recognize a gain or loss in earnings on assets or
liabilities it controls both before and after the business combination.
6.014 ASC paragraph 805-30-30-7 requires that consideration transferred in a business
combination is measured at the acquisition-date fair value. If the fair value of assets or
liabilities recognized as consideration transferred is different from the carrying amount of
those assets or liabilities, a gain or loss is recognized in earnings. However, this guidance
applies only if the acquirer does not retain control of the assets or liabilities transferred
after the acquisition.
Example 6.1: Consideration Includes a Cost Method Investment
ABC Corp. acquires a business from DEF Corp., and in exchange transfers cash and a
cost method investment in an unrelated entity to DEF. How should ABC measure the
consideration transferred?
ABC should include the fair value of the cost method investment as part of the
consideration transferred. To the extent the fair value differs from the book value of the
investment, ABC recognizes a gain or loss in earnings for the difference.
Example 6.2: Consideration Includes a Technology License
ABC Corp. acquires a business from DEF Corp., and in exchange transfers cash and
grants a software license for one of ABC’s products to DEF. How should ABC measure
the consideration transferred?
ABC should include the fair value of the license as part of the consideration transferred.
ABC would follow the appropriate revenue recognition guidance in GAAP to determine
when revenue recognition would be appropriate.
Assets or Liabilities Transferred to an Acquiree That Remain Under the Control of
the Acquirer Are Not Remeasured, and No Gain Or Loss Is Recognized
6.015 An acquirer may transfer a business or a subsidiary to the acquiree as consideration
in a business combination. Other forms of consideration transferred may include assets
and liabilities of a subsidiary, or other assets of the acquirer. Regardless of the structure
of the transaction, if the acquirer retains control of the transferred assets or liabilities after
the acquisition, it recognizes no gain or loss and measures those assets and liabilities at
their carrying amounts immediately before the acquisition.
6.016 Additionally, if an acquirer transfers an equity interest in a subsidiary, but
continues to hold a controlling financial interest in the subsidiary after the transfer, the
change in the parent’s ownership interest in the subsidiary is accounted for as an equity
transaction, and no gain or loss is recognized. Any difference between the fair value of
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6. Recognizing and Measuring the Consideration Transferred
the consideration received or paid and the amount by which the noncontrolling interest is
adjusted, is recognized in equity attributable to the parent. (ASC paragraph 810-10-45-
23). See Chapter 7 of KPMG Handbook, Consolidation, for further discussion.
6.017 The following are examples of business combinations in which an acquirer retains
control of assets and liabilities transferred in connection with a business combination.
These examples illustrate that, regardless of how a business combination is structured, if
the acquirer retains control of the assets and liabilities transferred after the acquisition, no
gain or loss is recognized.
Example 6.3: Transfer of a Subsidiary to an Acquiree
ABC Corp. transfers its wholly owned Subsidiary S to DEF Corp. in exchange for 60%
of the common shares of DEF. Subsidiary S and DEF are both businesses. The fair value
of the consideration transferred is equal to the fair value of the consideration received
(i.e., there is no bargain purchase). It was also determined that there is no minority
discount or control premium in this transaction.
(1) How should ABC account for this transaction in its consolidated financial
statements?
(2) How should DEF account for this transaction in its consolidated financial
statements?
Before Transaction
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6. Recognizing and Measuring the Consideration Transferred
After Transaction
(1) Accounting for the transaction in ABC’s consolidated financial statements
The acquisition of control of DEF by ABC is a business combination under ASC Topic
805, in which ABC is the acquirer and DEF is the acquiree. In applying the acquisition
method to the transaction, ABC recognizes and measures the assets acquired and
liabilities assumed based on the recognition and measurement requirements of ASC
Topic 805. However, ABC recognizes no gain or loss in earnings on the transaction:
• ABC controls the transferred asset (Subsidiary S) directly before the
transaction, and indirectly after the transaction (through its control of DEF).
Therefore, ABC continues to measure the assets and liabilities of Subsidiary S
following its acquisition of DEF at their carrying amounts immediately before
the acquisition, and does not recognize a gain or a loss in earnings on the
transfer of a 40% indirect ownership interest in Subsidiary S to the former
owners of DEF (consistent with the guidance in ASC paragraph 805-30-30-8).
• This transaction involves a reduction in the parent’s (ABC’s) ownership
interest in Subsidiary S (i.e., from a 100% direct controlling interest to a 60%
indirect controlling interest). However, because ABC continues to hold an
indirect controlling financial interest in Subsidiary S after the transaction, the
exchange by ABC of an indirect 40% interest in Subsidiary S is accounted for
as an equity transaction in ABC’s consolidated financial statements in
accordance with ASC paragraph 810-10-45-23, with no gain or loss
recognized in earnings on the exchange.
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6. Recognizing and Measuring the Consideration Transferred
Consequently, this transaction is recognized in ABC’s consolidated financial statements
as follows:
• ABC recognizes the net assets of its newly acquired subsidiary, DEF, in the
amount of $650, which equals the sum of ABC’s carrying amount of
Subsidiary S immediately preceding the transaction ($250) plus the $400
acquisition-date fair value of DEF. Note that ABC continues to consolidate
the net assets of Subsidiary S, and separately recognizes the noncontrolling
interest in Subsidiary S resulting from the transfer of a 40% indirect
ownership interest in Subsidiary S to the former owners of DEF (see below).
• ABC recognizes the noncontrolling interest in DEF of $260, which is equal to
40% of the historical carrying amount of Subsidiary S’s net assets
immediately preceding the acquisition of DEF (40% × $250, or $100), plus
40% of the fair value of DEF at the acquisition date (40% × $400, or $160).
• Because ABC retains control of Subsidiary S (indirectly, through its
acquisition of DEF) after the transaction, the transfer of a 40% indirect
interest in Subsidiary S to the noncontrolling interest in DEF (the former
owners of DEF) is accounted for as an equity transaction. Thus, the excess of
the fair value of the acquired interest in DEF (60% × $400, or $240) over the
historical carrying amount of the indirect interest transferred (40% × $250, or
$100), or $140, is credited to paid-in capital.
ABC will record the following entries in its consolidated financial statements to reflect
the acquisition of DEF:
Debit
Credit
Net assets of DEF
650
Net assets of Subsidiary S
Noncontrolling interest in DEF
Paid-in capital
250
260
140
(2) Accounting for the transaction in DEF’s consolidated financial statements
Because the former shareholder of Subsidiary S (ABC) receives the larger portion of the
voting interest in the combined entity (which includes Subsidiary S and DEF), and
assuming no other evidence indicates that DEF is the acquirer, this transaction should be
accounted for as the acquisition of DEF by Subsidiary S (i.e., a reverse acquisition in
which Subsidiary S effectively issues consideration equal to a 40% ownership interest in
Subsidiary S in exchange for the acquisition of a 60% ownership interest in DEF). See
Reverse Acquisitions beginning at Paragraph 9.012.
Thus, a business combination has occurred, with Subsidiary S being the accounting
acquirer and DEF the accounting acquiree. In DEF’s consolidated financial statements:
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6. Recognizing and Measuring the Consideration Transferred
• The net assets of DEF are recognized and measured at their acquisition-date
fair value, thus requiring an increase in their carrying amount of $200 ($400
fair value less $200 book value).
• The net assets of Subsidiary S are recognized at their historical carrying
amount of $250.
DEF’s consolidated financial statements should present the historical financial statements
of Subsidiary S before the acquisition as the historical financial statements. Thus, the
results of operations of DEF are included in the financial statements of the consolidated
entity only for periods after the acquisition date.
Although the equity of Subsidiary S (the accounting acquirer) is presented as the equity
of the combined entity, the capital stock account must be adjusted to reflect the
outstanding stock of DEF (the surviving entity). That is:
• The retained earnings of Subsidiary S would be presented as the retained
earnings of the combined entity.
• The capital stock account of the combined entity would reflect the par value
of DEF’s stock.
The additional paid-in capital account of Subsidiary S would be adjusted for the
difference between the capital stock account of Subsidiary S and the capital stock account
of DEF, and that adjusted amount would be presented as additional paid-in capital of the
combined entity.
This example presumes that both the entities are businesses. See Question 2.1.30 in
KPMG Handbook, Asset acquisitions, for guidance that addresses transactions
involving entities that do not meet the definition of a business.
Example 6.4: Shares of a Subsidiary Issued in a Business Combination
ABC Corp.’s wholly owned Subsidiary S issues new common shares representing a 40%
interest to shareholders of DEF Corp. in exchange for all of the common shares of DEF.
The fair value of the consideration transferred is equal to the fair value of the
consideration received (i.e., there is no bargain purchase). It was also determined that
there is no minority discount or control premium in this transaction.
How should ABC account for this transaction in its consolidated financial statements?
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6. Recognizing and Measuring the Consideration Transferred
Before Transaction
After Transaction
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6. Recognizing and Measuring the Consideration Transferred
The acquisition of control of DEF by ABC is a business combination under ASC Topic
805, in which Subsidiary S (ABC’s subsidiary) is the acquirer and DEF is the acquiree. In
applying the acquisition method to the transaction, Subsidiary S recognizes and measures
the assets acquired and liabilities assumed based on the recognition and measurement
principles of ASC Topic 805. However, no gain or loss is recognized on the transaction:
• ABC controls Subsidiary S both before and after the business combination.
Therefore, ABC continues to measure the assets and liabilities of Subsidiary S
following its acquisition of DEF at their carrying amounts immediately before
the acquisition, and does not recognize a gain or loss on the transfer of a 40%
noncontrolling interest in Subsidiary S to the former owners of DEF
(consistent with the guidance in ASC paragraph 805-30-30-8).
• Subsidiary S recognizes the net assets acquired in the acquisition of DEF at
their fair value of $400, and a corresponding increase in equity to reflect the
fair value of the shares issued to effect the acquisition. In consolidation, ABC
also recognizes the net assets acquired at their fair value of $400.
• This transaction also involves a reduction in the parent’s (ABC’s) ownership
interest in Subsidiary S (from 100% to 60%). However, because ABC
continues to control Subsidiary S after the transaction, the issuance of shares
by Subsidiary S to the noncontrolling interest (the former owners of DEF) is
accounted for by ABC as an equity transaction under ASC paragraph 810-10-
45-23, and no gain or loss is recognized on the issuance of the additional
shares of Subsidiary S to the former owners of DEF.
Consequently, this transaction is recognized in ABC’s consolidated financial statements
as follows:
• Subsidiary S recognizes the net assets resulting from the acquisition of DEF at
their fair value of $400, and ABC recognizes an increase in its investment in
Subsidiary S in the same amount. ABC continues to recognize its preexisting
investment in Subsidiary S at its historical carrying amount of $250
immediately preceding the transaction, resulting in an investment in
Subsidiary S of $650 ($400 + $250) after the transaction.
• ABC recognizes the noncontrolling interest in Subsidiary S of $260, which is
equal to 40% of the historical carrying amount of Subsidiary S immediately
before the acquisition of DEF by Subsidiary S (40% × $250, or $100), plus
40% of the fair value of DEF at the acquisition date (40% × $400, or $160).
• Because ABC retains control of Subsidiary S after the transaction, the transfer
of a 40% interest in Subsidiary S to the noncontrolling interest in Subsidiary S
(the former owners of DEF) is accounted for as an equity transaction. Thus,
the excess of the fair value of the acquired interest in DEF (60% × $400, or
$240) over the historical carrying amount of the interest transferred (40% ×
$250, or $100), which nets to $140, is credited to paid-in capital. The $140
credit to paid-in capital may be viewed as the gain resulting from the
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6. Recognizing and Measuring the Consideration Transferred
transaction with the noncontrolling interest, equal to the excess of the fair
value received of $240 over the carrying amount of the of the interest
transferred of $100.
ABC will record the following entries in its consolidated financial statements to reflect
the acquisition of DEF by Subsidiary S:
Debit
Credit
Net assets of Subsidiary S
400
Noncontrolling interest in DEF
Paid-in capital
260
140
Example 6.5: Acquisition Achieved in Stages Through the Exchange of an
Indirect Noncontrolling Interest in a Subsidiary, Including Payment of a
Control Premium
ABC Corp. owns 40% of the outstanding common stock of DEF Corp. (the carrying
amount of ABC’s investment in DEF was equal to 40% of the book value of DEF).
Public shareholders own the remaining 60% of DEF’s shares. DEF issues additional
shares of its common stock to ABC in exchange for 40% of the common stock of XYZ
Corp. (a wholly owned subsidiary of ABC). After the transaction, ABC owns a
controlling interest in DEF of 60%; the remaining 40% is owned by the public
shareholders. The fair value of the consideration transferred is equal to the fair value of
the consideration received (i.e., there is no bargain purchase). ABC pays a $20 control
premium to the public shareholders of DEF on this transaction, as explained below.
How should ABC account for this transaction in its consolidated financial statements?
Before Transaction
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6. Recognizing and Measuring the Consideration Transferred
Book value
Fair value:
Excluding control
premium
Control premium
Total fair value
DEF
XYZ
$ 150
250
$ 200
0 1
$ 200
375
75
450
1 There is no control premium in the fair value determined for DEF before this
transaction.
A control premium with respect to DEF arises as a result of this transaction, by which
ABC obtains control of DEF.
After Transaction
Fair value:
Excluding control
premium
Control premium
Total fair value
DEF
XYZ
$ 350
20
$ 370
375
75
450
The acquisition of control of DEF by ABC is a business combination under ASC Topic
805, in which ABC is the acquirer and DEF is the acquiree. In applying the acquisition
method to this transaction, ABC recognizes and measures the DEF assets acquired and
liabilities assumed in accordance with the recognition and measurement requirements of
ASC Topic 805.
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6. Recognizing and Measuring the Consideration Transferred
In this transaction, ABC effectively acquired a 20% additional interest in DEF from the
public shareholders in exchange for a 16% indirect interest in XYZ (effected by the
transfer of a 40% interest in XYZ to DEF, which is 40% owned by the public
shareholders on completion of the transaction; 40% × 40% =16%). ABC also pays a
control premium on this transaction of $20 as a result of its obtaining control of DEF. It
has been determined that the fair value of the control premium is $20.1
1 The following analysis demonstrates that ABC has paid and received equivalent
consideration:
Fair value of equity interest in XYZ that ABC transferred
($375 × 16%)
Fair value of additional equity interest in DEF received by ABC:
Excluding control premium (20% × $200)
Control premium
Fair value received by ABC (including ability to control DEF)
$ 60
$ 40
20
$ 60
Because ABC held a 40% interest in DEF before this transaction, the acquisition of
control of DEF results in a business combination achieved in stages (also referred to as a
step acquisition). In a business combination achieved in stages, the acquirer remeasures
its previously held equity interest in the acquiree at its acquisition-date fair value and
recognizes the resulting gain or loss, if any, in earnings. See discussion of Business
Combinations Achieved in Stages (Step Acquisitions) in Section 9.
This transaction also results in a reduction of ABC’s direct controlling ownership of XYZ
(from 100% to 60%), offset by an increase in ABC’s indirect ownership of XYZ of 24%
(through its 60% ownership of DEF and DEF’s ownership of 40% of XYZ on completion
of the transaction; 60% × 40% = 24%), and a transfer of a 16% indirect ownership
interest in XYZ to the public shareholders of DEF (through the public shareholders’
ownership of 40% of DEF and DEF’s ownership of 40% of XYZ on completion of the
transaction; 40% × 40% = 16%). However, ABC continues to control XYZ after the
transaction (through its 60% direct ownership interest and its 24% indirect ownership
interest). Thus, ABC accounts for its exchange of a 16% interest in XYZ as an equity
transaction under ASC paragraph 810-10-45-23, with no gain or loss recognized in
income on the exchange.
ABC records the following entries in its consolidated financial statements:
• ABC remeasures its 40% interest in DEF immediately preceding this
transaction at its acquisition-date fair value of $80 ($40% × $200), and
recognizes the resulting gain of $20 in earnings. The $20 gain is equal to the
excess of the fair value of ABC’s 40% interest of $80 over its carrying amount
of $60 (40% × $150).
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6. Recognizing and Measuring the Consideration Transferred
• ABC recognizes the net assets of its newly acquired subsidiary, DEF, at their
acquisition-date fair value of $220 (which includes the $20 control premium).
Note that ABC continues to consolidate the net assets of XYZ, and separately
recognizes the noncontrolling interest in XYZ resulting from the transfer of a
16% indirect interest in XYZ to the public shareholders of DEF (see below).
• ABC eliminates the carrying amount of its investment in DEF of $80 before
the acquisition (the sum of the historical carrying amount of its investment
before this transaction ($60), plus the $20 gain recognized from the
remeasurement of that investment to fair value).
• ABC recognizes the noncontrolling interest in DEF of $120, which is equal to
40% of the historical carrying amount of the 40% interest in XYZ that was
transferred to DEF (40% × $100), or $40, plus 40% of the fair value of DEF at
the acquisition date, exclusive of the control premium, all of which is
ascribable to ABC (40% × $200), or $80).
• Because ABC retains control of XYZ after the transaction, it accounts for the
transfer of a 16% indirect interest in XYZ to the public shareholders of DEF
as an equity transaction, with no gain or loss recognized in income. Thus, the
excess of the fair value of the acquired 20% interest in DEF of $60 (20% × the
fair value of DEF of $200, or $40, plus the control premium of $20), over the
historical carrying amount of the 16% indirect interest transferred to the
public shareholders of $40 (16% × $250), which nets to $20, is credited to
paid-in capital. The $20 credit to paid-in capital can be viewed as the gain
resulting from the transaction with the noncontrolling interest, equal to the
excess of the fair value received of $60 over the $40 carrying amount of the
consideration transferred.
ABC would record the following entries in its consolidated financial statements to reflect
this transaction:
Investment in affiliate - DEF
Gain
Net assets of DEF
Investment in affiliate - DEF
Noncontrolling interest in DEF
Paid-in capital
Debit
Credit
20
220
20
80
120
20
Control Premium Realized by Public Shareholders
Note that the public shareholders of DEF have realized the benefit of the $20 control
premium paid by ABC:
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6. Recognizing and Measuring the Consideration Transferred
Before the transaction:
60% interest × $200 fair value of DEF
After the transaction:
40% interest × $200 fair value of DEF (exclusive of
the control premium which is ascribable to ABC)
16% indirect interest × $375 fair value of XYZ
Net premium received by public shareholders
Fair Value of
Public
Shareholders’
Interests
$
120
$
$
$
80
60
140
20
The $20 control premium is equal to the difference between the fair value of the 16%
indirect interest in XYZ received by the public shareholders (16% × $375), or $60, and
the 20% of the fair value of DEF effectively sold to ABC (20% × $200), or $40.
Although the fair value of the noncontrolling interest in DEF is $140 (40% × $350), ABC
recognizes this in its consolidated financial statements at $120, due to the measurement
of DEF’s interest in XYZ using ABC’s carryover basis.
SHARE-BASED PAYMENT AWARDS INCLUDED IN THE CONSIDERATION
TRANSFERRED
ASC Paragraph 805-30-30-9
An acquirer may exchange its share-based payment awards for awards held by
grantees of the acquiree. This Topic refers to such awards as replacement awards.
Exchanges of share options or other share-based payment awards in conjunction
with a business combination are modifications of share-based payment awards in
accordance with [ASC] Topic 718. If the acquirer is obligated to replace the
acquiree awards, either all or a portion of the fair-value-based measure of the
acquirer’s replacement awards shall be included in measuring the consideration
transferred in the business combination. The acquirer is obligated to replace the
acquiree awards if the acquiree or its grantees have the ability to enforce
replacement. For example, for purposes of applying this requirement, the acquirer
is obligated to replace the acquiree’s awards if replacement is required by any of
the following:
a. The terms of the acquisition agreement
b. The terms of the acquiree’s awards
c. Applicable laws or regulations.
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6. Recognizing and Measuring the Consideration Transferred
ASC Paragraph 805-30-30-10
In situations in which acquiree awards would expire as a consequence of a
business combination and the acquirer replaces those awards even though it is not
obligated to do so, all of the fair-value-based measure of the replacement awards
shall be recognized as compensation cost in the postcombination financial
statements. That is, none of the fair-value-based measure of those awards shall be
included in measuring the consideration transferred in the business combination.
6.018 See discussion of Acquirer Share-Based Payment Awards Exchanged for Awards
Held by the Grantees of the Acquiree in Section 11.
CONTINGENT CONSIDERATION
ASC Master Glossary: Contingent Consideration
Usually an obligation of the acquirer to transfer additional assets or equity
interests to the former owners of an acquiree as part of the exchange for control of
the acquiree if specified future events occur or conditions are met. However,
contingent consideration also may give the acquirer the right to the return of
previously transferred consideration if specified conditions are met.
ASC Paragraph 805-30-25-5
The consideration the acquirer transfers in exchange for the acquiree includes any
asset or liability resulting from a contingent consideration arrangement. The
acquirer shall recognize the acquisition-date fair value of contingent consideration
as part of the consideration transferred in exchange for the acquiree.
ASC Paragraph 805-30-25-6
The acquirer shall classify an obligation to pay contingent consideration as a
liability or as equity in accordance with [ASC] Subtopics 480-10 [Distinguishing
Liabilities from Equity - Overall] and [ASC] 815-40 [Derivatives and Hedging -
Contracts in Entity’s Own Equity] or other applicable generally accepted
accounting principles (GAAP). For example, [ASC] Subtopic 480-10 provides
guidance on whether to classify as a liability a contingent consideration
arrangement that is, in substance, a put option written by the acquirer on the
market price of the acquirer’s shares issued in the business combination.
ASC Paragraph 805-30-25-7
The acquirer shall classify as an asset a right to the return of previously
transferred consideration if specified conditions are met.
6.019 Contingent consideration refers to a payment that is contingent upon meeting
certain conditions or the occurrence of a particular event. When negotiating the
transaction price of a business, contingent consideration is often used to bridge the price
gap between what the seller would like to receive and what the buyer is willing to pay.
For example, additional consideration may be paid if the acquired business meets certain
financial targets (e.g., revenue, EBITDA, operating profit), passes regulatory reviews,
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6. Recognizing and Measuring the Consideration Transferred
achieves certain litigation outcomes, or develops a product. Contingent consideration can
also be used as a means of deferred financing or incentive for management performance
(see Section 11 for accounting for transactions that compensate employees or former
owners of the acquiree for future service). Contingent consideration is usually paid in the
form of cash or equity. Additionally, if the acquired business had contingent
consideration arrangements from acquisitions it made before its acquisition by the
acquirer, the acquiree’s preexisting contingent consideration becomes contingent
consideration for the acquirer. However, unlike consideration of the acquirer, preexisting
contingent consideration is accounted for as an assumed liability (or asset acquired) in the
business combination rather than part of consideration transferred.
6.020 If the business combination requires a stated minimum amount of additional
consideration to be paid to the former owners of the acquiree after the acquisition date,
this obligation is defined and not contingent and should not be accounted for as part of a
contingent consideration arrangement, regardless of how the acquisition agreement
characterizes the obligation. Noncontingent obligations should be measured at fair value
at the acquisition date as part of the consideration transferred. The acquirer should
measure and account for a noncontingent obligation to deliver a minimum level of
additional consideration in the future based on other applicable GAAP, depending on the
nature of the obligation. ASC Subtopic 835-30, Interest - Imputation of Interest, provides
guidance on the subsequent measurement of debt obligations. Examples 6.11 and 6.17
involve both (a) an obligation to deliver a minimum amount of consideration in the future
and (b) an obligation under a contingent consideration arrangement.
WORKING CAPITAL
6.020a Adjustments to the consideration transferred based on net working capital at the
acquisition date are not contingent consideration arrangements, because they relate to
conditions that existed at the acquisition date and do not depend on future events.
Working capital adjustments paid or received during the measurement period would be
adjustments to the consideration transferred in accordance with the measurement period
guidance in ASC subparagraph 805-10-25-15(b). However, working capital adjustments
paid or received after the close of the measurement period would be recorded to income.
CONSIDERATION HELD IN ESCROW FOR GENERAL REPRESENTATIONS AND
WARRANTIES
6.020b Many business combination agreements require consideration to be held in an
escrow account pending the seller’s satisfaction of general representations and warranties
(i.e., those not related to a specific asset or liability). Typically, general representations
and warranties are expected to be valid and relate to conditions that exist as of the
acquisition date rather than contingent on a future event. Therefore, settlements of
general representations and warranties are not contingent consideration and any
consideration held in escrow for this purpose is typically part of the consideration
transferred.
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6. Recognizing and Measuring the Consideration Transferred
6.020c In addition, the acquirer would need to assess the escrow agreement to determine
whether the escrowed funds continue to qualify as an asset on its balance sheet, and if so,
recognize a corresponding liability for any funds expected to be paid to the sellers.
6.020d See Paragraph 7.168 for discussion about whether reimbursement for general
representations and warranties should be accounted for as an indemnification asset. See
Paragraph 12.033 for a discussion of evaluating contingencies that arise from disputes
around the purchase price, including when seeking enforcement of an escrow
arrangement.
FORMS OF CONTINGENT CONSIDERATION
6.021 Contingent consideration may include the issuance of additional securities or
distribution of other consideration on resolution of contingencies based on post-
combination earnings, post-combination security prices, or other factors.
6.022 Examples of contingent consideration include the following:
• Contingent Consideration Based on Earnings. Consideration may be
contingent on maintaining or achieving specified earnings levels in future
periods. An acquirer may be required to issue additional shares of its common
shares to the former shareholders of the acquiree if earnings of the acquiree
reach a certain level for a specified period.
• Contingent Consideration Based on Components of Earnings.
Consideration could be contingent on components of earnings such as revenue
growth, cost containment, or EBITDA. An acquirer may be required to pay
additional consideration to the acquiree’s previous owners based on the
number of units or dollar amount of sales of specified products sold by the
acquirer for the five-year period following the acquisition date.
• Contingent Consideration That Represents a Guarantee of Security
Price. Contingent consideration is sometimes issued to guarantee the price of
securities issued by the acquirer in an acquisition. This type of guarantee is
generally in the form of an agreement by the acquirer to issue additional
shares of shares, cash, or other consideration if the market (fair) value of the
acquirer’s securities issued to the former shareholders of the acquiree does not
reach the guaranteed value by a specified date or maintain the guaranteed
value for a stipulated period of time.
• Redeemable Preferred Shares and Put Options. A guarantee of the value of
shares issued as consideration in a business combination may be embedded in
the securities, i.e., the shares unconditionally issued at the date of acquisition
are puttable for the guaranteed value at the option of the holder (i.e., the
holder may demand cash in exchange for the shares). Alternatively, in
addition to the shares issued to effect the combination, an acquirer could issue
put options that give the holder the right to return the shares to the acquirer for
the guaranteed value.
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6. Recognizing and Measuring the Consideration Transferred
• Below-Market Guarantee. A purchase agreement may include an
arrangement for the purchaser to issue additional consideration to the seller
that guarantees a minimum value or security price at a future date that is less
than the value or security price at the date the securities are issued (below-
market guarantee).
• Contingent Consideration That Does Not Guarantee Security Price. The
purchase agreement may include an arrangement for the acquirer to issue
additional consideration to the seller based on security prices at a future date,
but does not result in a guarantee of the total value of the consideration issued
by the acquirer. An acquirer may agree to issue a fixed amount of additional
shares should the fair value of the shares originally issued be less than a target
value at a specified future date.
INITIAL RECOGNITION OF CONTINGENT CONSIDERATION
6.023 While the amount of future payments by the acquirer resulting from contingent
consideration issued in an acquisition is conditional based on future events, the acquirer’s
obligation regarding the contingent consideration is unconditional and meets the
definition of a liability in FASB Concepts Statement No. 6, Elements of Financial
Statements. Contingent consideration issued by an acquirer in a transaction accounted for
as a business combination is recognized at the acquisition date at its acquisition-date fair
value as part of the consideration transferred in the acquisition. (ASC paragraph 805-30-
25-5) See Section 18, Determining the Fair Value of the Consideration Transferred in a
Business Combination, for additional discussion.
6.024 Contingent consideration issued in a business combination is classified at the
acquisition date as either equity, or as an asset or a liability, based on applicable GAAP.
The accounting for contingent consideration after an acquisition depends on whether the
obligation for contingent consideration is classified as equity or as a liability (or in some
cases, as an asset).
• Contingent consideration classified as equity is not remeasured after the
acquisition date, and subsequent settlement is accounted for within equity.
• Contingent consideration classified as a liability (or an asset) is remeasured to
fair value at each reporting date until the contingency is resolved. The changes
in fair value are recognized in earnings (i.e., operating income) unless the
arrangement is a derivative that has been designated as a hedging instrument
in a cash flow hedging relationship for which ASC Topic 815, requires the
changes to be initially recognized in other comprehensive income.
6.025 See the discussion of the initial measurement of contingent consideration in
Section 18, Determining the Fair Value of the Consideration Transferred in a Business
Combination, and the discussion of the subsequent accounting for contingent
consideration in Section 12, Subsequent Measurement and Accounting.
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6. Recognizing and Measuring the Consideration Transferred
STATEMENT OF CASH FLOWS
6.026 See chapter 18 of KPMG Handbook, Statement of cash flows.
6.026a Paragraph not used.
Examples 6.5a and 6.5b Not used.
DETERMINING THE CLASSIFICATION OF CONTINGENT CONSIDERATION
6.027 ASC paragraphs 805-30-25-6 and 25-7 require an acquirer to classify an obligation
to pay contingent consideration as a liability or as equity based on ASC Subtopic 480-10,
ASC Subtopic 815-40, or other applicable GAAP. The guidance in these and other
relevant pronouncements should be considered in determining the classification of
contingent consideration issued in a business combination.
6.028 ASC Subtopics 480-10 and 815-40 generally apply to financial instruments (a) for
which the payoff to the counterparty is based, in whole or in part, on variations in the fair
value of the issuer’s own shares (or the shares of a consolidated subsidiary of the issuer)
or (b) that are potentially settled in the issuer’s own shares (or the shares of a
consolidated subsidiary of the issuer). The first step in the determination of whether a
contingent consideration arrangement is classified as a liability or equity requires a
determination of whether the arrangement has either of those characteristics. If neither of
those characteristics is present, the contingent consideration arrangement is a liability
under ASC Topic 805 and no further analysis of classification is necessary. However, if
either of those characteristics is applicable to the contingent consideration arrangement,
the guidance in this Section should be applied to determine the arrangement’s
classification. Contingent consideration arrangements that meet either of those
characteristics are referred to herein as equity-linked contingent consideration
arrangements.
Example 6.6: Cash-Settled Contingent Consideration Based on Earnings
ABC Corp. acquires DEF Corp. and the terms of the acquisition agreement provide for
contingent consideration to be paid in cash two years after the acquisition date. The value
of that consideration ranges between $0 and $20 million and is calculated according to an
earnings-based formula.
Analysis. This example does not involve an equity-linked contingent consideration
arrangement, so there is no GAAP that could potentially result in equity classification.
The arrangement should be classified as a liability.
6.029 ASC Subtopics 480-10 and 815-40 are complex, and a complete discussion of
those standards is beyond the scope of this publication. However, an overview of those
standards and their application to contingent consideration arrangements is presented
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6. Recognizing and Measuring the Consideration Transferred
below. For a more detailed discussion of these and related standards, refer to the
following KPMG Handbooks.
• Debt and equity financing
• Derivatives and hedging (As amended by ASU 2017-12), Chapters 2 and 3
• Derivatives and hedging (Pre-ASU 2017-12), Sections 2 and 3
6.030 This flowchart illustrates the process for evaluating whether to classify an
obligation to pay contingent consideration as a liability or as equity in accordance with
ASC Subtopics 480-10 and 815-40:
6.031 We believe that certain business combinations may contain multiple contingent
consideration arrangements. In those circumstances, the guidance in ASC Subtopics 480-
10 and 815-40, and other U.S. GAAP would be applied to each arrangement and the
classification of each of those individual arrangements as liabilities or equity may differ.
See additional discussion in the subsection titled Determining the Unit(s) of Accounting
When a Business Combination Potentially Involves More Than One Contingent
Consideration Arrangement.
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6. Recognizing and Measuring the Consideration Transferred
Classification of Equity-Linked Contingent Consideration Arrangements That Are
Within the Scope of ASC Subtopic 480-10
6.032 ASC paragraph 480-10-35-4A requires that financial instruments within its scope
that are issued as consideration in a business combination be classified as liabilities (or in
some instances, assets). ASC Subtopic 480-10 applies to the following three classes of
freestanding financial instruments that embody obligations for the issuer:
(1) Mandatorily Redeemable Financial Instruments (ASC paragraphs 480-
10-25-4 through 25-7). A mandatorily redeemable financial instrument is a
financial instrument issued in the form of shares that embodies an
unconditional obligation requiring the issuer to redeem the instrument by
transferring its assets at a specified or determinable date (or dates) or on an
event certain to occur. Mandatorily redeemable financial instruments are not
classified as liabilities if redemption is only required to occur on the
liquidation or termination of the reporting entity. Similarly, mandatorily
redeemable noncontrolling interests in a consolidated subsidiary are not
classified as liabilities in the consolidated financial statements of the parent if
redemption is only required to occur on the liquidation or termination of the
subsidiary, even if the parent entity will not be liquidated or terminated at the
redemption date. Additionally, for non-SEC registrants only, mandatorily
redeemable financial instruments are not classified as liabilities unless they
are redeemable on fixed dates for amounts that are fixed or determined by
reference to specified indices. (See ASC paragraphs 480-10-15-7E to 15-7F
for additional information about noncontrolling interests that are mandatorily
redeemable only on liquidation of the subsidiary and certain mandatorily
redeemable financial instruments issued by non-SEC registrants.)
(2) Obligations to Repurchase the Issuer’s Shares by Transferring Assets
(ASC paragraphs 480-10-25-8 through 25-13). A financial instrument, other
than an outstanding share, that, at inception, (a) embodies an obligation to
repurchase the issuer’s equity shares or is based on variations in the fair value
of the obligation, and (b) requires or may require the issuer to settle the
obligation by transferring assets, is within the scope of ASC Subtopic 480-10.
Examples include forward purchase contracts or written put options on the
issuer’s equity shares that are physically settled or net-cash-settled, put
warrants, and warrants on shares that are redeemable.
(3) Certain Obligations to Issue a Variable Number of Shares (ASC
paragraph 480-10-25-14). A financial instrument that embodies an
unconditional obligation (or a financial instrument other than an outstanding
share that embodies a conditional obligation) that the issuer must or may settle
by issuing a variable number of its equity shares is within the scope of ASC
Subtopic 480-10 and is classified as a liability (or an asset in some instances)
if, at inception, the monetary value of the obligation is based solely or
predominantly on any of the following:
(a) A fixed monetary amount known at inception (e.g., share-settled debt),
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6. Recognizing and Measuring the Consideration Transferred
(b) Variations in something other than the fair value of the issuer’s equity
shares (e.g., a financial instrument indexed to the S&P 500 and settleable
with a variable number of the issuer’s shares), or
(c) Variations inversely related to changes in the fair value of the issuer’s
equity shares (e.g., a written put option that could be net share settled).
6.033 ASC Subtopic 480-10 applies to freestanding financial instruments, including those
that comprise more than one option or forward contract, and its guidance applies to an
instrument in its entirety (i.e., ASC Subtopic 480-10 does not apply to embedded
features). A freestanding financial instrument is a financial instrument that is entered into
separately and apart from the entity’s other financial instruments or equity transactions,
or that is entered into in conjunction with some other transaction and is legally detachable
and separately exercisable. In determining whether a feature is a freestanding financial
instrument within the scope of ASC Subtopic 480-10 or an embedded feature, significant
judgment is often required. However, ASC Topic 805 always requires a contingent
consideration arrangement issued in a business combination to be recognized as a
separate unit of accounting (i.e., either as a liability or equity). ASC paragraph 805-30-
25-6 specifies that the analysis of whether a contingent consideration arrangement is a
liability requires that the arrangement be evaluated based on the classification guidance
contained in ASC Subtopics 480-10 and 815-40, and other relevant GAAP. Based on that
guidance, we believe that the evaluation of whether a contingent consideration
arrangement should be classified as a liability or as equity would require consideration of
the classification requirements in ASC Subtopic 480-10, regardless of whether the
arrangement is otherwise considered to be embedded in the related acquisition agreement.
6.034 Although ASC Subtopic 480-10 specifies certain types of financial instruments that
are required to be classified as liabilities (or assets in some instances), it does not provide
guidance on determining whether a financial instrument should be classified as equity.
Consequently, if the guidance in ASC Subtopic 480-10 does not require a contingent
consideration arrangement to be classified as a liability, further analysis of other
applicable guidance (e.g., ASC Subtopic 815-40) is required to determine the
arrangement’s classification as a liability or equity.
For further guidance about financial instruments that are required to be classified as
liabilities (or assets) under ASC Subtopic 480-10, see KPMG Handbook, Debt and equity
financing, chapter 6, Distinguishing liabilities from equity.
Illustrations of Contingent Consideration Arrangements That Are Classified as
Liabilities Under ASC Subtopic 480-10
6.035 The following examples illustrate the evaluation of whether contingent
consideration arrangements are required to be classified as liabilities under ASC Subtopic
480-10.
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6. Recognizing and Measuring the Consideration Transferred
Example 6.7: Contingent Consideration That Embodies a Written Put
Option
ABC Corp. acquires DEF Corp. by unconditionally issuing 1 million common shares at
the date of acquisition. The fair value of those shares at the date of acquisition is $50
million ($50 per share). Under the terms of the acquisition agreement, the former
shareholders of DEF can require ABC to repurchase those common shares at the end of 4
years for $50 per share. In lieu of purchasing the shares, ABC can elect to satisfy its
obligation by making a cash payment equal to 1 million times the excess of $50 over
ABC’s share price at the end of the 4-year period.
Analysis. The contingent consideration arrangement should be classified as a liability
based on the classification guidance in ASC paragraph 480-10-25-8. In this example, the
contingent consideration arrangement (a) is not an outstanding share, (b) embodies an
obligation to repurchase its equity shares (in this case it is a conditional obligation), and
(c) may require ABC to settle the obligation by transferring assets (i.e., ABC can either
repurchase 1 million shares for $50 million or make a cash payment equal to 1 million
times the excess of $50 over ABC’s share price).
Example 6.8: Contingent Consideration That Embodies a Guarantee of the
Acquirer’s Share Price
ABC Corp. acquires DEF Corp. by unconditionally issuing 1 million common shares at
the date of acquisition. The fair value of those shares at the date of acquisition is $30
million ($30 per share). ABC also agrees to issue additional shares if the fair value of its
common shares is less than $50 per share at the end of 4 years such that the value of the
shares issued to acquire DEF will be at least $50 million.
Analysis. The contingent consideration arrangement should be classified as a liability
based on the classification guidance in ASC paragraph 480-10-25-14(c). In this example,
the contingent consideration arrangement (a) embodies a conditional obligation and is not
an outstanding share, (b) the issuer must settle the obligation by delivering a variable
number of common shares (i.e., if ABC’s share price is less than $50 per share at the end
of 4 years), and (c) has a monetary value, at inception, that is based on variations
inversely related to changes in the fair value of its common shares (i.e., the monetary
value of the consideration that must be delivered to the former shareholders of DEF
increases as ABC’s stock price declines).
Example 6.9: Contingent Consideration in the Form of a Freestanding
Financial Instrument
ABC Corp. acquires DEF Corp. by unconditionally issuing 1 million common shares at
the date of acquisition. ABC also issues a freestanding written put option to the former
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6. Recognizing and Measuring the Consideration Transferred
shareholders of DEF that permits those holders to sell (put) 500,000 shares of ABC’s
common shares to ABC in exchange for $25 million ($50 per share) at the end of 4 years.
At ABC’s option, the put option can either be physically settled or it can be net-cash
settled by making a cash payment equal to 500,000 times the excess of $50 over ABC’s
share price.
Analysis. The contingent consideration arrangement should be classified as a liability
based on the classification guidance in ASC paragraph 480-10-25-8. In this example, the
contingent consideration arrangement (a) is not an outstanding share, (b) embodies an
obligation of the issuer to repurchase its equity shares (in this case it is a conditional
obligation), and (c) may require ABC to settle the obligation by transferring assets (i.e.,
ABC can either repurchase 500,000 shares for $25 million or make a cash payment equal
to 500,000 times the excess of $50 over ABC’s share price).
Example 6.10: Contingent Consideration Based on Earnings
ABC Corp. acquires DEF Corp. and the terms of the acquisition agreement provide for
contingent consideration to be paid two years after the acquisition date. The value of that
consideration ranges between $0 and $20 million and is calculated based on an earnings-
based formula. ABC can elect to settle its obligation under the contingent consideration
arrangement in cash or a variable number of its common shares with an equivalent value.
Analysis. The contingent consideration arrangement should be classified as a liability
based on the classification guidance in ASC paragraph 480-10-25-14(b). In this example,
the contingent consideration arrangement (a) embodies a conditional obligation and is not
an outstanding share, (b) may be settled by delivering a variable number of common
shares, and (c) has a monetary value, at inception, that is based on variations in
something other than the issuer’s stock price. ABC’s earnings are the sole basis for the
monetary value of the obligation. Although ABC’s share price affects the number of
shares delivered at settlement, its stock price does not affect the monetary value of that
consideration.
Example 6.11: Fixed Minimum Payment and Contingent Consideration
Based on Earnings
ABC Corp. acquires DEF Corp. and the terms of the acquisition agreement provide for
additional consideration to be paid two years after the acquisition date. The value of that
additional consideration ranges between $30 million and $50 million and is calculated
according to an earnings-based formula. ABC can elect to settle its obligation under the
arrangement in cash or a variable number of its common shares with an equivalent value.
Analysis. Regardless of how the acquisition agreement characterizes the arrangement, the
$30 million minimum consideration to be transferred at the end of 2 years is
noncontingent and should not be accounted for as contingent consideration. Rather, the
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6. Recognizing and Measuring the Consideration Transferred
obligation to deliver cash or a variable number of shares worth $30 million in 2 years
represents a separate accounting unit and should be recognized as a debt obligation at the
acquisition date and initially measured at fair value, with the resulting debt discount
amortized to interest expense using the effective interest method over the 2-year period.
The contingent consideration arrangement represents the conditional obligation to remit
up to $20 million of additional consideration (i.e., the amount in excess of the $30 million
minimum) at the end of 2 years based on an earnings formula. That arrangement should
be classified as a liability based on the classification guidance in ASC paragraph 480-10-
25-14(b). In this example, the contingent consideration arrangement (a) embodies a
conditional obligation and is not an outstanding share, (b) may be settled by delivering a
variable number of common shares, and (c) has a monetary value, at inception, that is
based on variations in something other than the issuer’s stock price. ABC’s earnings are
the sole basis of the monetary value of the obligation. Although ABC’s stock price
affects the number of shares delivered at settlement, its stock price does not affect the
monetary value of that consideration.
Classification of Equity-Linked Contingent Consideration Arrangements That Are
Not Within the Scope of ASC Subtopic 480-10
6.036 For an equity-linked contingent consideration arrangement issued in a business
combination that is not required to be classified as a liability in accordance with ASC
Subtopic 480-10, other GAAP that provides guidance on the classification of equity-
linked contracts must be applied to determine the classification of the arrangement.
Applying the guidance in other GAAP requires that both of the following two criteria be
met for a contingent consideration arrangement to be classified as equity:
(a) The arrangement must be considered to be indexed to the entity’s own stock
based on the guidance in ASC paragraphs 815-40-15-5 through 15-8; and
(b) The arrangement must meet the conditions for equity classification in ASC
Section 815-40-25.
6.037 If the contingent consideration arrangement does not meet either of these criteria, it
would be classified as a liability, regardless of whether the arrangement has all the
characteristics of a derivative in ASC paragraphs 815-10-15-71, 15-83, 15-85, 15-89, 15-
90, 15-92 through 15-96, 15-99, 15-100, 15-110, 15-119, 15-120, and 15-128.
6.037a In August 2020, the FASB issued ASU 2020-06, Accounting for Convertible
Instruments and Contracts in an Entity’s Own Equity. The ASU aims to simplify the
accounting for convertible instruments. Prior to the ASU, ASC Section 815-40-25
included seven additional conditions that preclude a contract from being classified in
equity (or preclude an embedded derivative from meeting the derivative scope exception)
because they may – or will – result in the contract being settled in cash rather than shares.
The FASB removed three of those conditions and clarified another. The ASU could affect
an entity’s analysis of the guidance in the preceding paragraphs.
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6. Recognizing and Measuring the Consideration Transferred
6.037b The ASU is effective for public business entities that are SEC filers and are not
eligible to be a smaller reporting company for annual and interim periods beginning after
December 15, 2021. The ASU is effective for all other entities for annual and interim
periods beginning after December 15, 2023. ASU 2020-06 can be early adopted no
earlier than fiscal years beginning after December 15, 2020, including interim periods
within those fiscal years. An entity adopts the guidance at the beginning of its annual
fiscal year.
For further guidance about classification of equity-linked contracts under Subtopic 815-
40, see the following chapters of KPMG Handbook, Debt and equity financing.
• Chapter 8, Contracts in an entity’s own equity (before ASU 2020-06)
• Chapter 8A, Contracts in an entity’s own equity (after ASU 2020-06)
Determining Whether a Contingent Consideration Arrangement Is Indexed to an
Entity’s Own Stock under ASC Paragraphs 815-40-15-5 through 15-8
6.038 ASC paragraphs 815-40-15-5 through 15-8 establish a framework for determining
whether an instrument (or embedded feature) is indexed to an entity’s own stock. When
an equity-linked contingent consideration arrangement is not required to be classified as a
liability under ASC Subtopic 480-10, the guidance in ASC paragraphs 815-40-15-5
through 15-8 is applied in determining whether it should be considered indexed to the
entity’s own stock, which is one of the requirements for the arrangement to be classified
as equity.
6.039 The decision process for determining whether an equity-linked financial instrument
is indexed to an entity’s own stock under ASC paragraphs 815-40-15-5 through 15-8 is
illustrated through a number of examples presented as illustrations in ASC paragraphs
815-40-55-26 through 55-48.
6.040 ASC paragraphs 815-40-15-5 through 15-8 require an entity to evaluate whether an
equity-linked financial instrument (or embedded feature) is indexed to its own stock
using a two-step approach:
Step 1: Evaluate the instrument’s contingent exercise provisions, if any. (ASC
paragraphs 815-40-15-7A and 15-7B)
Step 2: Evaluate the instrument’s settlement provisions. (ASC paragraphs 815-40-
15-7C through 15-7H)
Step 1: Evaluate Contingent Exercise Provisions
6.041 In applying ASC paragraphs 815-40-15-5 through 15-8, an exercise contingency is
a provision that entitles the entity (or the counterparty) to exercise an equity-linked
financial instrument (or embedded feature) based on changes in an underlying (as defined
in ASC Topic 815), including the occurrence (or nonoccurrence) of a specified event. An
exercise contingency would not preclude an instrument from being considered indexed to
an entity’s own stock, provided that it is not based on:
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6. Recognizing and Measuring the Consideration Transferred
(a) An observable market, other than the market for the issuer’s stock (if
applicable), or
(b) An observable index, other than an index calculated or measured solely by
reference to the issuer’s own operations (e.g., sales revenue of the issuer,
EBITDA (earnings before interest, taxes, depreciation, and amortization) of
the issuer, net income of the issuer, or total equity of the issuer).
6.042 If the evaluation of Step 1 does not preclude a contingent consideration
arrangement from being considered indexed to an entity’s own stock under ASC
paragraphs 815-40-15-7A and 15-7B, the analysis proceeds to Step 2 of that model (ASC
paragraphs 815-40-15-7C through 15-7H).
6.043 For a contingent consideration arrangement, the guidance in Step 1 would apply to
a contingency that causes the transfer of consideration to be triggered or that causes the
arrangement to be terminated. However, if the amount of consideration to be transferred
(or forfeited) is adjusted when an exercise contingency occurs, the exercise contingency
would be evaluated under Step 1 and the potential adjustment to the amount of
consideration would be evaluated under Step 2. For example, if the achievement of an
earnings target for a specified period triggers payment under a contingent consideration
arrangement and the amount of that payment varies based on the level of those earnings,
then the arrangement should be evaluated under both Step 1 and Step 2 of the model
(ASC paragraph 815-40-15-7). See Example 6.12 for an illustration of those
circumstances.
Step 2: Evaluate Settlement Provisions
6.044 If an instrument’s settlement provisions provide for a settlement amount equal to
the difference between the fair value of a fixed number of an entity’s equity shares and a
fixed monetary amount or a fixed amount of a debt instrument issued by the entity, the
instrument would be considered indexed to an entity’s own stock under ASC paragraph
815-40-15-7C. An issued share option that gives the counterparty a right to buy a fixed
number of an entity’s shares for a fixed price or for a fixed stated principal amount of a
bond issued by the entity would be considered indexed to the entity’s own stock. Certain
all or nothing contingent consideration arrangements, as discussed below, would meet
this fixed-for-fixed criterion and be considered indexed to an entity’s own stock.
6.045 An instrument’s strike price or the number of shares used to calculate the
settlement amount are not fixed if its terms provide for potential adjustment, regardless of
the probability of such adjustment(s) or whether such adjustments are in the entity’s
control. If an instrument’s strike price or the number of shares used to calculate the
settlement amount are not fixed, but the only variables that could affect the settlement
amount are inputs to the fair value of a fixed-for-fixed forward or option on equity shares,
the instrument would still be considered indexed to an entity’s own stock under ASC
paragraph 815-40-15-7D.
6.046 The fair value inputs of a fixed-for-fixed forward or option on equity shares may
include additional variables beyond the entity’s stock price, such as the strike price of the
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6. Recognizing and Measuring the Consideration Transferred
instrument, term of the instrument, expected dividends or other dilutive activities, stock
borrow cost, interest rates, stock price volatility, the entity’s credit spread, and the ability
to maintain a standard hedge position. Determinations and adjustments related to the
settlement amount (including determination of the ability to maintain a standard hedge
position) must be commercially reasonable. An instrument (or embedded feature) would
not be considered indexed to the entity’s own stock if its settlement amount is affected by
variables that are extraneous to the pricing of a fixed-for-fixed option or forward contract
on equity shares. If an instrument’s settlement calculation incorporates variables other
than those used to determine the fair value of a fixed-for-fixed forward or option on
equity shares, or if the instrument contains a feature (such as a leverage factor) that
increases exposure to the additional variables listed above in a manner that is inconsistent
with a fixed-for-fixed forward or option on equity shares, the instrument (or embedded
feature) would not be considered indexed to the entity’s own stock.
All or Nothing Contingent Consideration Arrangements
6.047 Consistent with the preceding discussion, a contingent consideration arrangement
that provides for a settlement amount based on the difference between the fair value of a
fixed number of the acquirer’s shares and a fixed monetary amount, which may be zero
(i.e., an all or nothing arrangement) would meet the fixed-for-fixed criteria in Step 2 of
the model (ASC paragraph 815-40-15-7E). If the contingency that triggers payment of
the consideration (i.e., an exercise contingency) is based on an observable market other
than the market for the issuer’s stock (if applicable), or is based on an observable index
other than an index calculated or measured solely by reference to the issuer’s own
operations, the arrangement would not be considered indexed to the acquirer’s own stock
under Step 1 and the arrangement would be classified as a liability. See Example 6.16 for
an illustration of an all or nothing arrangement.
Illustration of the Application of ASC Subtopic 480-10 and ASC Paragraphs 815-40-
15-5 through 15-8 to a Contingent Consideration Arrangement
6.048 The following example illustrates the evaluation of whether a contingent
consideration arrangement is required to be classified as a liability under ASC Subtopic
480-10 and ASC paragraphs 815-40-15-5 through 15-8.
Example 6.12: Contingent Consideration That Provides for Different
Outcomes Involving the Issuance of Shares That Are Based on the Level
of Revenues Achieved
ABC Corp. acquires DEF Corp. by unconditionally issuing 1 million common shares at
the date of acquisition. Under the terms of the acquisition agreement, ABC is required
to issue 100,000 additional shares if the revenues of DEF are at least $10 million in the
year following the acquisition or 150,000 additional shares if the revenues of DEF are
at least $12 million for that year.
Analysis under ASC Subtopic 480-10. In this example, the contingent consideration
arrangement is not a liability under ASC paragraph 480-10-25-8 because (a) it does not
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6. Recognizing and Measuring the Consideration Transferred
embody an obligation to repurchase the issuer’s shares (nor is it indexed to such an
obligation) and (b) it would not require the issuer to settle the obligation by transferring
assets. The determination of whether this contingent consideration arrangement should
be classified as a liability under ASC paragraph 480-10-25-14 depends on the entity’s
assessment of the predominant nature of the monetary value that will be received by
the counterparty at settlement.
The monetary value of the consideration to be delivered at settlement varies in the
same direction as ABC’s stock price (i.e., the monetary value of the consideration
increases when the stock price increases, and vice versa). However, the monetary value
of the consideration to be delivered at settlement also varies based on changes in
something other than the fair value of ABC’s equity shares (i.e., the monetary value of
the consideration is affected by the entity’s revenues, which determines the number of
shares to be delivered at settlement). The monetary value of the consideration to be
delivered at settlement is affected by a variable that would meet the characteristic in
ASC paragraph 480-10-25-14(b) (i.e., its monetary value varies based on something
other than the fair value of ABC’s equity shares) if it were the sole variable affecting
the monetary value of the obligation. Consequently, the entity must evaluate whether
the overall monetary value of the obligation is predominantly based on variations in
revenues. Significant judgment is often required when assessing predominance under
ASC paragraph 480-10-25-14. If ABC concludes based on the relevant facts and
circumstances that the monetary value of the arrangement is predominantly based on
variations in something other than the fair value of its equity shares (i.e., the entity’s
revenues), the contingent consideration arrangement would be classified as a liability
under ASC Subtopic 480-10.
Analysis under ASC paragraphs 815-40-15-5 through 15-8. If ABC concludes
based on the relevant facts and circumstances that the monetary value of the
arrangement is not predominantly based on variations in something other than the fair
value of its equity shares (i.e., the entity’s revenues), the arrangement would not be
within the scope of ASC Subtopic 480-10. However, the contingent consideration
arrangement is not considered indexed to ABC’s own stock under ASC paragraphs
815-40-15-5 through 15-8 and, therefore, is required to be classified as a liability based
on the following evaluation:
Step 1. The exercise contingency (i.e., the accumulation of at least $10 million of
revenues in the 3-year period following the acquisition) is an observable index.
However, it can only be calculated or measured by reference to ABC’s own operations,
so the evaluation of Step 1 does not preclude the arrangement from being considered
indexed to the entity’s own stock. Proceed to Step 2.
Step 2. The consideration paid at settlement would not equal the difference between a
fixed number of the entity’s equity shares and a fixed strike price. Although the strike
price to be received at settlement ($0) is fixed, the number of shares to be issued to the
counterparty is not fixed (i.e., 100,000 shares if revenues are greater than $10 million
but less than $12 million in the year following the acquisition and 150,000 shares if
revenues for that year are at least $12 million). The amount of an entity’s annual
revenues is not an input to the fair value of a fixed-for-fixed option on equity shares.
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6. Recognizing and Measuring the Consideration Transferred
Determining Whether a Contingent Consideration Arrangement Is Classified in
Equity under ASC Section 815-40-25
6.049 ASC Section 815-40-25 addresses the classification and measurement of contracts
that are indexed to, and potentially settled in, a company’s own stock. If an entity
concludes that (a) a contingent consideration issued in a business combination is not
required to be classified as a liability under ASC Subtopic 480-10 and (b) the
arrangement is indexed to the entity’s own stock under ASC paragraphs 815-40-15-5
through 15-8, then the classification guidance in ASC Section 815-40-25 is applied to
determine the arrangement’s classification as a liability or equity.
6.050 ASC Section 815-40-25 generally bases classification on the concept that contracts
that may require net-cash settlement are assets or liabilities and contracts that permit or
require settlement in shares are equity. If a contract provides the entity with a choice of
net-cash settlement or settlement in shares, settlement in shares is assumed; if a contract
provides the counterparty with a choice of net-cash settlement or settlement in shares,
settlement in cash is assumed. However, these general principles do not apply when the
settlement alternatives do not have the same economic value or if one of the alternatives
is fixed or has caps or floors. In that case, the economic substance of the transaction
should be the basis for the classification. However, the principles do apply when the
settlement alternatives have different economic values if the reason for the difference is a
limit on the number of shares that the entity must deliver under a net-share settlement
alternative.
6.051 Based on the model described in the preceding paragraph, a contingent
consideration arrangement that is evaluated under ASC Section 815-40-25 (i.e., liability
classification is not otherwise required under ASC Subtopic 480-10 or ASC paragraphs
815-40-15-5 through 15-8) would be classified as a liability or equity in the following
circumstances unless the economic substance indicates otherwise:
Equity Classified
• Contracts that require physical settlement in shares (including gross or net-
share settlement), provided that all of the conditions in ASC Section 815-40-
25 are met; and
• Contracts that give the issuer a choice of net-cash settlement or settlement in
its own shares (physical settlement or net-share settlement), provided that all
of the conditions in ASC Section 815-40-25 are met.
Liability Classified
• Contracts that require net-cash settlement (including a requirement to net cash
settle the contract if an event occurs and that event is outside the control of the
issuer); and
• Contracts that give the counterparty a choice of net-cash settlement or
physical settlement in shares (gross settlement or net-share settlement).
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6. Recognizing and Measuring the Consideration Transferred
ASC Section 815-40-25 specifies several additional conditions necessary for equity
classification. If those conditions are not met, the entity may be forced to net-cash settle
the equity-linked financial instrument, which typically causes an instrument to fail the
requirements of the equity classification guidance.
Reclassifications of Contingent Consideration Arrangements
6.052 The classification of a contingent consideration arrangement that is evaluated under
ASC Section 815-40-25 is reassessed at each balance sheet date, including the additional
conditions that must be met for equity classification. If the classification of a contingent
consideration arrangement changes as a result of events during the period, the
arrangement should be reclassified as of the date of the event that caused the
reclassification. There is no limit to the number of times an equity-linked contingent
consideration arrangement may be reclassified. If an arrangement is reclassified from
equity to a liability, the change in the fair value of the arrangement during the period(s) in
which it was classified as equity should be accounted for as an adjustment to equity. The
arrangement should subsequently be measured at fair value with changes in fair value
reported in earnings (i.e., operating income). If an arrangement is reclassified from a
liability to equity, gains or losses recorded to account for the arrangement at fair value
during the period(s) in which it was classified as a liability should not be reversed.
Example 6.13: Reclassification of a Contingent Consideration Arrangement
from Equity to a Liability
A contingent consideration arrangement is not required to be classified as a liability
under ASC Subtopic 480-10 and it is initially classified as equity based on the guidance
in ASC paragraphs 815-40-15-5 through 15-8 and ASC Section 815-40-25. However,
due to the issuance of shares in a subsequent period, the entity no longer has sufficient
authorized and unissued shares available to settle its obligations under the arrangement.
Consequently, the arrangement no longer meets the condition for equity classification
described in ASC paragraphs 815-40-25-19 through 25-24.
Analysis. The contingent consideration arrangement should be reclassified from equity
to a liability as of the date that the requirements for equity classification were no longer
met. The liability should be recorded at its fair value on the date of reclassification with
an offsetting adjustment to equity. The arrangement should subsequently be measured at
fair value with changes in fair value reported in earnings (i.e., operating income).
Example 6.14:Reclassification of a Contingent Consideration Arrangement
from a Liability to Equity
A contingent consideration arrangement is not required to be classified as a liability
under ASC Subtopic 480-10 and it is considered indexed to the entity’s own stock under
ASC paragraphs 815-40-15-5 through 15-8. However, the arrangement requires the entity
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6. Recognizing and Measuring the Consideration Transferred
to net-cash settle any obligations under the arrangement if registered shares are not
available to satisfy the obligation. Consequently, the arrangement does not meet the
conditions for equity classification described in ASC Section 815-40-25, and it is initially
classified as a liability. The contingent consideration arrangement is subsequently
amended to permit the entity to settle any obligations under the arrangement by
delivering unregistered shares if registered shares are not available. Additionally, the
amended arrangement does not include any provision that could require net-cash
settlement, and the remaining conditions for equity classification in ASC Section 815-40-
25 are met.
Analysis. The contingent consideration arrangement should be reclassified from a
liability to equity at its carrying amount (i.e., its fair value) as of the reclassification date.
Gains or losses previously recognized when the arrangement was classified as a liability
should not be reversed.
Illustrations of the Application of ASC Subtopic 480-10, ASC Paragraphs 815-40-
15-5 through 15-8, and ASC Section 815-40-25 to Contingent Consideration
Arrangements
6.053 The following examples illustrate the evaluation of whether contingent
consideration arrangements are required to be classified as liabilities or equity under ASC
Subtopic 480-10, ASC paragraphs 815-40-15-5 through 15-8, and ASC Section 815-40-
25.
Example 6.15: Contingent Consideration That Embodies a Net-Share
Settled Written Call Option
ABC Corp. acquires DEF Corp. by unconditionally issuing 1 million common shares at
the date of acquisition. The fair value of those shares at the date of acquisition is $50
million ($50 per share). Under the terms of the acquisition agreement, if ABC’s share
price exceeds $50 per share at the end of 4 years, ABC must deliver a variable number of
registered shares with a fair value equal to 1 million times the amount of ABC’s share
price in excess of $50 to the former shareholders of DEF. The arrangement includes a
provision that explicitly requires net-cash settlement if registered shares are not available
to satisfy ABC’s obligation, if any, at the end of 4 years.
Analysis under ASC Subtopic 480-10. ASC Subtopic 480-10 does not require the
contingent consideration arrangement in this example to be classified as a liability. The
arrangement is not a liability under ASC paragraph 480-10-25-8 because (a) it does not
embody an obligation to repurchase the issuer’s shares (nor is it indexed to such an
obligation) and (b) it would not require the issuer to settle the obligation by transferring
assets. The arrangement (a) embodies a conditional obligation and is not an outstanding
share, and (b) may require ABC to settle the obligation by delivering a variable number
of its common shares (i.e., if ABC’s share price exceeds $50 at the end of 4 years).
However, the arrangement is not a liability under ASC paragraph 480-10-25-14, because
the monetary value of that obligation, at inception, is based solely on variations directly
related to changes in the fair value of its common shares.
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6. Recognizing and Measuring the Consideration Transferred
Analysis under ASC paragraphs 815-40-15-5 through 15-8. The contingent
consideration arrangement is considered indexed to ABC’s own stock under ASC
paragraphs 815-40-15-5 through 15-8 based on the following evaluation:
Step 1. The arrangement does not contain an exercise contingency. Proceed to Step 2.
Step 2. The consideration paid at settlement would equal the difference between the fair
value of a fixed number of the entity’s equity shares (1 million shares) and a fixed strike
price ($50 per share).
Analysis under ASC Section 815-40-25. The contingent consideration arrangement in
this example explicitly requires net-cash settlement if ABC is unable to settle its
obligation by delivering registered shares, which precludes equity classification under
ASC Section 815-40-25.
Conclusion. The contingent consideration arrangement does not meet the conditions for
equity classification in ASC Section 815-40-25, so it should be classified as a liability.
Example 6.16: Contingent Consideration That Provides for the Issuance of
a Fixed Number of Shares Payable on the Achievement of an Earnings
Target
ABC Corp. acquires DEF Corp. by unconditionally issuing 1 million common shares at
the date of acquisition. Under the terms of the acquisition agreement, ABC is required to
issue 100,000 additional shares if the revenues of DEF are at least $10 million in the year
following the acquisition. The arrangement does not include a provision that could
require net-cash settlement and it meets the additional conditions for equity classification
prescribed in ASC Section 815-40-25.
Analysis under ASC Subtopic 480-10. ASC Subtopic 480-10 does not require the
contingent consideration arrangement in this example to be classified as a liability. The
arrangement is not a liability under ASC paragraph 480-10-25-8 because (a) it does not
embody an obligation to repurchase the issuer’s shares (nor is it indexed to the
obligation) and (b) it would not require the issuer to settle the obligation by transferring
assets. Additionally, the arrangement is not a liability under ASC paragraph 480-10-25-
14 because it does not embody an obligation that ABC may settle by issuing a variable
number of its shares (it embodies an obligation that ABC may be required to settle by
delivering a fixed number of its shares).
Analysis under ASC paragraphs 815-40-15-5 through 15-8. The contingent
consideration arrangement is considered indexed to ABC’s own stock under ASC
paragraphs 815-40-15-5 through 15-8 based on the following evaluation:
Step 1. The exercise contingency (i.e., the accumulation of at least $10 million of
revenues) is an observable index. However, it can only be calculated or measured by
reference to ABC’s own operations, so the evaluation of Step 1 does not preclude the
arrangement from being considered indexed to the entity’s own stock. Proceed to Step 2.
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6. Recognizing and Measuring the Consideration Transferred
Step 2. The consideration paid at settlement would equal the difference between the fair
value of a fixed number of the entity’s equity shares (100,000 shares) and a fixed strike
price ($0).
Analysis under ASC Section 815-40-25. The arrangement in this example does not
include a provision that could require net-cash settlement and it meets the additional
conditions for equity classification prescribed in ASC Section 815-40-25.
Conclusion. The contingent consideration arrangement is not required to be classified as
a liability under ASC Subtopic 480-10; it is considered indexed to the entity’s own stock
under ASC paragraphs 815-40-15-5 through 15-8, and it meets the conditions for equity
classification in ASC Section 815-40-25. The arrangement should be classified as equity.
Example 6.17: Fixed Minimum Number of Shares and Contingent
Consideration That Provides for the Issuance of a Fixed Number of
Additional Shares Payable on the Achievement of an Earnings Target
ABC Corp. acquires DEF Corp. by unconditionally issuing 1 million common shares at
the date of acquisition. Under the terms of the acquisition agreement, ABC is required to
issue 100,000 additional shares in 3 years to the former shareholders of DEF if total
EBITDA of DEF for the 3-year period following the acquisition is less than $10 million.
However, if total EBITDA for that period is at least $10 million, the number of shares to
be delivered at the end of 3 years increases to 500,000. The arrangement does not include
a provision that could require net-cash settlement and it meets the additional conditions
for equity classification prescribed in ASC Section 815-40-25.
Analysis under ASC Subtopic 480-10. Regardless of how the arrangement is
characterized in the acquisition agreement, the 100,000 minimum additional shares to be
transferred at the end of 3 years is noncontingent and should not be accounted for as
contingent consideration. Rather, the unconditional obligation to deliver 100,000 shares
in 3 years represents a separate accounting unit. That obligation is not a liability under
ASC paragraph 480-10-25-8 because (a) it does not embody an obligation to repurchase
the issuer’s shares (nor is it indexed to such an obligation) and (b) it would not require
the issuer to settle the obligation by transferring assets. Additionally, the unconditional
obligation to deliver 100,000 shares in 3 years is not a liability under ASC paragraph
480-10-25-14, because it does not embody an obligation that ABC may settle by issuing a
variable number of its shares (that accounting unit embodies an obligation that ABC will
be required to settle by delivering a fixed number of its shares).
The contingent consideration arrangement represents a conditional obligation to remit
400,000 of additional shares (i.e., the amount in excess of the 100,000 minimum) at the
end of 3 years based on an EBITDA target. That arrangement is not a liability under ASC
paragraph 480-10-25-8, because (a) it does not embody an obligation to repurchase the
issuer’s shares (nor is it indexed to such an obligation) and (b) it would not require the
issuer to settle the obligation by transferring assets. Additionally, the contingent
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6. Recognizing and Measuring the Consideration Transferred
consideration arrangement is not a liability under ASC paragraph 480-10-25-14, because
it does not embody an obligation that ABC may settle by issuing a variable number of its
shares (the contingent consideration arrangement embodies a conditional obligation that
would be settled by delivering 400,000 of ABC’s shares, a fixed number).
Analysis under ASC paragraphs 815-40-15-5 through 15-8. The unconditional
obligation to deliver 100,000 shares in 3 years is considered indexed to ABC’s own stock
under ASC paragraphs 815-40-15-5 through 15-8 based on the following evaluation:
Step 1. The obligation to deliver 100,000 shares at the end of 3 years does not contain an
exercise contingency. Proceed to Step 2.
Step 2. The consideration paid at settlement would equal the difference between the fair
value of a fixed number of the entity’s equity shares (100,000 shares) and a fixed strike
price ($0).
The contingent consideration arrangement represents the conditional obligation to remit
400,000 of additional shares (i.e., the amount in excess of the 100,000 minimum) at the
end of 3 years based on an EBITDA target. That arrangement is considered indexed to
ABC’s own stock under ASC paragraphs 815-40-15-5 through 15-8 based on the
following evaluation:
Step 1. The exercise contingency (i.e., the accumulation of at least $10 million of total
EBITDA in the 3-year period following the acquisition) is an observable index. However,
it can only be calculated or measured by reference to ABC’s own operations, so the
evaluation of Step 1 does not preclude the arrangement from being considered indexed to
the entity’s own stock. Proceed to Step 2.
Step 2. The consideration paid at settlement would equal the difference between the fair
value of a fixed number of the entity’s equity shares (400,000 shares) and a fixed strike
price ($0).
Analysis under ASC Section 815-40-25. Neither the fixed obligation to deliver 100,000
shares in 3 years nor the contingent consideration arrangement includes a provision that
could require net-cash settlement. Additionally, those obligations meet the additional
conditions for equity classification that are prescribed in ASC Section 815-40-25.
Conclusion. Neither the fixed obligation to deliver 100,000 shares in 3 years nor the
contingent consideration arrangement is required to be classified as a liability under ASC
Subtopic 480-10. In addition, they are both considered indexed to the entity’s own stock
under ASC paragraphs 815-40-15-5 through 15-8, and they both meet the conditions for
equity classification in ASC Section 815-40-25. Both the fixed obligation to deliver
100,000 shares in 3 years and the contingent consideration arrangement should be
classified as equity.
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6. Recognizing and Measuring the Consideration Transferred
Example 6.18: Contingent Consideration Based on the Acquirer’s Stock
Price
ABC Corp. acquires DEF Corp. by unconditionally issuing 1 million common shares at
the date of acquisition. The fair value of those shares at the date of acquisition is $30
million ($30 per share). ABC also agrees to issue additional shares to the former
shareholders of DEF if the fair value of its common shares is less than $60 per share at
the end of 4 years. If ABC’s stock price is between $20 and $60 per share at the end of 4
years, ABC will issue a variable number of shares to achieve an overall target value of
$60 million (including the fair value at the end of 4 years of the 1 million shares issued at
acquisition). However, if ABC’s stock price is less than $20 per share at the end of 4
years, 2 million additional shares will be issued. The arrangement does not include a
provision that could require net-cash settlement and it meets the additional conditions for
equity classification prescribed in ASC Section 815-40-25.
Analysis under ASC Subtopic 480-10. In this example, the contingent consideration
arrangement is not a liability under ASC paragraph 480-10-25-8, because (a) it does not
embody an obligation to repurchase the issuer’s shares (nor is it indexed to such an
obligation) and (b) it would not require the issuer to settle the obligation by transferring
assets.
However, the determination of whether this contingent consideration arrangement should
be classified as a liability under ASC paragraph 480-10-25-14 depends on the entity’s
assessment of the predominant nature of the monetary value of the consideration that
would be transferred at settlement. If ABC’s stock price is less than $20 per share at
settlement, the holder is entitled to 2 million shares and the monetary value of that
consideration varies in the same direction as changes in the fair value of the entity’s
shares. However, when ABC’s stock price is greater than $20 but less than $60 at
settlement, the holder is entitled to a variable number of shares with a monetary value
that varies inversely with changes in the fair value of the entity’s common shares. In
other words, when ABC’s stock price is between $20 and $60 per share, the monetary
value of the shares that would be delivered at settlement moves in the opposite direction
of its stock price. For example, if ABC’s stock price is $30 at settlement, the counterparty
would receive 1 million shares with a fair value of $30 million. However, if ABC’s stock
price is $50 at settlement, the counterparty would receive 200,000 shares with a fair value
of $10 million. Because the contingent consideration arrangement is comprised of
multiple options embodying obligations to issue shares and one of those component
obligations meets the characteristics in ASC paragraph 480-10-25-14(c) (i.e., its
monetary value varies inversely to changes in ABC’s stock price), the entity must
evaluate whether that component obligation is predominant relative to the other
component obligations. Significant judgment is often required when assessing
predominance under ASC paragraph 480-10-25-14. If ABC concludes based on the
relevant facts and circumstances that the component obligation with a monetary value
that varies inversely to its stock price is predominant relative to the component obligation
without that characteristic, the contingent consideration arrangement would be classified
as a liability under ASC Subtopic 480-10.
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6. Recognizing and Measuring the Consideration Transferred
Analysis under ASC paragraphs 815-40-15-5 through 15-8. If ABC concludes based
on the relevant facts and circumstances that the component obligation with a monetary
value that varies inversely to its stock price is not predominant relative to the component
obligation(s) without that characteristic, the arrangement would not be a liability under
ASC Subtopic 480-10. The contingent consideration arrangement is considered indexed
to ABC’s own stock under ASC paragraphs 815-40-15-5 through 15-8 based on the
following evaluation:
Step 1. The arrangement does not contain an exercise contingency. Proceed to Step 2.
Step 2. The consideration paid at settlement would not equal the difference between a
fixed number of the entity’s equity shares and a fixed strike price. Although the strike
price to be received at settlement ($0) is fixed, the number of shares to be issued to the
counterparty varies based on ABC’s stock price at the settlement date. Because the only
variable that can affect the settlement amount is the entity’s stock price, which is an input
to the fair value of a fixed-for-fixed option contract on equity shares, the arrangement is
considered indexed to the entity’s own stock.
Analysis under ASC Section 815-40-25. The arrangement in this example does not
include a provision that could require net-cash settlement and it meets the conditions for
equity classification that are prescribed in ASC Section 815-40-25.
Conclusion. As discussed above, classification of the contingent consideration
arrangement in this example depends on the entity’s evaluation of predominance for
purposes of evaluating classification under ASC Subtopic 480-10. If ABC concludes
based on the relevant facts and circumstances that the component obligation with a
monetary value that varies inversely to its stock price is predominant relative to the
component obligation(s) without that characteristic, the contingent consideration
arrangement would be classified as a liability under ASC Subtopic 480-10. If not, the
arrangement would be classified as equity because it is considered indexed to the entity’s
own stock under ASC paragraphs 815-40-15-5 through 15-8 and it meets the conditions
for equity classification in ASC Section 815-40-25.
DETERMINING THE UNIT(S) OF ACCOUNTING FOR CONTINGENT
CONSIDERATION
6.054 Contingent consideration in a business combination may contain multiple
contingent payment triggers. ASC Topic 805 does not specify whether these payments
should be viewed as multiple units of accounting or a single unit of accounting. The
determination is important because it may affect the presentation as liabilities or equity
under ASC Subtopic 480-10, ASC paragraphs 815-40-15-5 through 15-8, ASC Section
815-40-25, and other relevant GAAP. It also may affect the presentation in the statement
of cash flows.
6.055 Whether contingent consideration in a business combination should be viewed as
multiple units of accounting or a single unit of accounting is a matter of judgment that
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6. Recognizing and Measuring the Consideration Transferred
depends on the substance of the arrangement, rather than the manner in which the
contingent consideration provisions are characterized in the related legal documents.
Additionally, that determination is not affected by whether the contingent consideration
provisions are prescribed in separate legal documents (i.e., papered separately) or within
the same document.
6.055a We believe that payments with discrete risk exposures would be separate units of
accounting. For example, if a business combination’s contingent consideration provisions
embody separate payment triggers applicable to multiple discrete reporting periods, and
the consideration that would be delivered on the attainment of each trigger would not be
affected by the outcome(s) of the payment triggers for other reporting periods, then it
would be appropriate to conclude that the contingent consideration consists of separate
units of accounting for each reporting period. In contrast, if in substance the contingent
consideration is based on a single risk exposure, the arrangement would be viewed as a
single unit of accounting, regardless of the payment structure. If there are multiple
scheduled payments, ordinarily the interim payments would need to be subject to a
clawback to conclude that there is only a single risk exposure and therefore a single unit
of accounting.
Example 6.19: Determining the Unit(s) of Accounting for Contingent
Consideration – Scenario 1
ABC Corp. acquires DEF Corp. and the terms of the acquisition agreement provide for
contingent consideration to be paid to the former shareholders of DEF as follows:
100,000 shares of ABC’s common shares if DEF’s cumulative EBITDA for the 3-year
period following the acquisition is more than $1 million but less than $2 million; 200,000
shares if cumulative EBITDA for the same 3-year period is at least $2 million but less
than $3 million; and 300,000 shares if cumulative EBITDA for that 3-year period is at
least $3 million.
Analysis. In this example, the contingent consideration provisions do not involve
separate payment triggers based on discrete risk exposures. Rather, those provisions
embody an obligation to deliver a variable number of shares that is determined based on
cumulative EBITDA for the 3-year period following the acquisition. The contingent
consideration arrangement should be viewed as a single unit of accounting and
classification of the arrangement as a liability or equity should be determined based on
the guidance in ASC Subtopic 480-10, ASC paragraphs 815-40-15-5 through 15-8, ASC
Section 815-40-25, and other relevant GAAP. Under that guidance, the arrangement
would be classified as a liability (see Example 6.12 for a detailed description of how a
similar arrangement would be evaluated under ASC Subtopic 480-10 and ASC
paragraphs 815-40-15-5 through 15-8).
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6. Recognizing and Measuring the Consideration Transferred
Example 6.20: Determining the Unit(s) of Accounting for Contingent
Consideration – Scenario 2
ABC Corp. acquires DEF Corp. in 20X5 and the terms of the acquisition agreement
provide for contingent consideration to be paid to the former shareholders of DEF as
follows: 100,000 shares of ABC’s common shares if DEF’s EBITDA is at least $1
million in 20X6; 100,000 shares if EBITDA is at least $1 million in 20X7; and 100,000
shares if EBITDA is at least $1 million in 20X8.
Analysis. In this example, the payment triggers are based on discrete risk exposures.
Specifically, the contingent consideration provisions embody separate payment triggers
based on DEF’s EBITDA for three independent reporting periods. The outcome of the
payment trigger for a particular reporting period does not affect the consideration to be
transferred in other periods. The business combination can be viewed as having three
separate contingent consideration arrangements for 20X6, 20X7, and 20X8, respectively.
Each of those contingent consideration arrangements would represent a separate unit of
accounting and the classification of those arrangements as liabilities or equity should be
determined based on the guidance in ASC Subtopic 480-10, ASC paragraphs 815-40-15-
5 through 15-8, ASC Section 815-40-25, and other relevant GAAP.
6.056 In some instances, the determination of the appropriate unit of accounting may not
be clear. For example, contingent consideration provisions may provide for separate
payment triggers for multiple reporting periods that would each require delivery of
consideration that is not affected by the outcome of triggers in other periods; however,
one or more of those payment triggers may be based on a cumulative performance
measure that overlaps with the periods covered by earlier triggers. All facts and
circumstances should be considered and judgment will be necessary when determining
the appropriate unit(s) of accounting for contingent consideration.
SUBSEQUENT ISSUANCE OF CONTINGENT SHARES BASED ON EARNINGS IN A
REVERSE ACQUISITION
6.057 Contingent shares issued to the stockholders of the accounting acquirer based on
earnings in a reverse acquisition should be accounted for similar to a stock dividend and
included in earnings per share from the date of issuance. Contingent shares issued to the
former stockholders of the legal acquirer based on earnings in a reverse acquisition
should be accounted for as contingent consideration.
Effect of Contingent Consideration on the Computation of Earnings Per Share
6.058 An agreement to provide consideration contingent on future earnings may affect an
acquirer’s computation of earnings per share during the contingency period if the
agreement requires the issuance of additional common shares on resolution of the
contingency.
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6. Recognizing and Measuring the Consideration Transferred
6.059 ASC paragraph 260-10-45-13 indicates that shares issuable for little or no cash
consideration on the satisfaction of certain conditions (contingently issuable shares)
should be considered outstanding common shares and included in the computation of
basic earnings per share (EPS) as of the date that all necessary conditions have been
satisfied (in essence, when issuance of the shares is no longer contingent). For instance, if
the earnings level stipulated in the contingency agreement is being attained currently, the
additional shares to be issued should not be considered outstanding for the purposes of
basic EPS until the earnings level is attained and the end of the contingency period is
reached, but the additional shares would be included in diluted EPS when the earnings
level is being currently attained (see following paragraphs). If the earnings levels were
not being attained currently, the contingently issuable shares would not be included in
basic or diluted EPS. Contingently issuable shares include shares that (a) will be issued in
the future on the satisfaction of specified conditions, (b) have been placed in escrow and
all or part must be returned if specified conditions are not met, or (c) have been issued but
the holder must return all or part if specified conditions are not met.
6.060 ASC paragraphs 260-10-45-48 through 45-50 indicate that shares whose issuance
is contingent on the satisfaction of certain conditions should be considered outstanding
and included in the computation of diluted EPS as follows:
(a) If all necessary conditions have been satisfied by the end of the period (the
events have occurred), those shares should be included as of the beginning of
the period in which the conditions were satisfied.
(b) If all necessary conditions have not been satisfied by the end of the period, the
number of contingently issuable shares included in diluted EPS should be
based on the number of shares, if any, that would be issuable if the end of the
reporting period were the end of the contingency period (e.g., the number of
shares that would be issuable based on current period earnings or period-end
market price) and if the result would be dilutive. Those contingently issuable
shares should be included in the denominator of diluted EPS as of the
beginning of the period (or the date of the acquisition if later).
6.061 A determination of whether contingently issuable shares are considered
outstanding for the purposes of computing both basic and diluted EPS data should be
made for each period, including interim periods, that EPS data are presented. Contingent
shares included in previously presented diluted EPS data because the earnings level had
been attained should not be included in computing diluted EPS for the current period if
the specified earnings level is not being attained currently.
6.062 EPS data previously presented should not be restated to give retroactive effect to
shares issued as a result of subsequently meeting the earnings level specified in the
contingent consideration arrangement.
Effect of Contingency Based on Security Prices in Computing Earnings Per Share
6.063 ASC paragraph 260-10-45-52 provides guidance on the treatment of contingently
issuable shares in EPS calculations when the number of contingently issuable shares
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6. Recognizing and Measuring the Consideration Transferred
depends on the market price of the stock at a future date. In that case, computations of
diluted EPS should reflect the number of shares that would be issued based on the current
market price at the end of the period being reported on if the effect is dilutive. If the
condition is based on an average of market prices over a period of time, the average for
that period should be used. Because the market price may change in a future period, basic
EPS should not include such contingently issuable shares because all necessary
conditions have not been satisfied.
Effect of Contingency Based on Both Future Earnings and Security Prices in
Computing Earnings Per Share
6.064 ASC paragraph 260-10-45-53 provides guidance on computing EPS when
contingently issuable shares depend on both future earnings and future market prices of
the common stock. In that case, the determination of the number of shares included in
diluted EPS should be based on both conditions, that is, earnings to date and current
market price, as they exist at the end of each reporting period. If both conditions are not
met at the end of the reporting period, no contingently issuable shares should be included
in diluted EPS.
BUSINESS COMBINATIONS IN WHICH NO CONSIDERATION IS
TRANSFERRED
6.065 In business combinations in which no consideration is transferred, an acquirer uses
the acquisition-date fair value of its interest in the acquiree, determined using one or
more valuation approaches, instead of the acquisition-date fair value of the consideration
transferred to determine the amount of goodwill. See discussion of Business
Combinations Achieved without the Transfer of Consideration in Section 9.
MEASUREMENT OF CONSIDERATION TRANSFERRED IN COMBINATIONS
INVOLVING MUTUAL ENTITIES
ASC Paragraph 805-30-55-3
When two mutual entities combine, the fair value of the equity or member
interests in the acquiree (or the fair value of the acquiree) may be more reliably
measurable than the fair value of the member interests transferred by the acquirer.
In that situation, [ASC] paragraphs 805-30-30-2 through 30-3 requires the
acquirer to determine the amount of goodwill by using the acquisition-date fair
value of the acquiree’s equity interests instead of the acquisition-date fair value of
the acquirer’s equity interests transferred as consideration. In addition, the
acquirer in a combination of mutual entities shall recognize the acquiree’s net
assets as a direct addition to capital or equity in its statement of financial position,
not as an addition to retained earnings, which is consistent with the way in which
other types of entities apply the acquisition method.
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6. Recognizing and Measuring the Consideration Transferred
ASC Paragraph 805-30-55-4
Although they are similar in many ways to other businesses, mutual entities have
distinct characteristics that arise primarily because their members are both
customers and owners. Members of mutual entities generally expect to receive
benefits for their membership, often in the form of reduced fees charged for goods
and services or patronage dividends. The portion of patronage dividends allocated
to each member is often based on the amount of business the member did with the
mutual entity during the year.
ASC Paragraph 805-30-55-5
A fair value measurement of a mutual entity should include the assumptions that
market participants would make about future member benefits as well as any
other relevant assumptions market participants would make about the mutual
entity. For example, an estimated cash flow model may be used to determine the
fair value of a mutual entity. The cash flows used as inputs to the model should be
based on the expected cash flows of the mutual entity, which are likely to reflect
reductions for member benefits, such as reduced fees charged for goods and
services.
6.066 A mutual entity is an entity other than an investor-owned entity that provides
dividends, lower costs, or other economic benefits directly to its owners, members, or
participants. For example, a mutual insurance company, a credit union, and a cooperative
entity, are all mutual entities. ASC Section 805-10-20
6.067 When a business combination takes place between mutual entities, the acquisition
method is applied. In a combination involving mutual entities, the acquirer and acquiree
exchange only equity interests. If the fair value of the equity or member interests in the
acquiree is more reliably measurable than the fair value of the member interests
transferred by the acquirer, ASC Topic 805 requires the acquirer to determine the amount
of goodwill by using the acquisition-date fair value of the acquiree’s equity interests
instead of the acquirer’s equity interests transferred as consideration.
6.068 The acquirer in a combination of mutual entities recognizes the acquiree’s net
assets as a direct addition to capital or equity in its balance sheet and not as an addition to
retained earnings.
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Section 7 - Recognizing and Measuring
the Identifiable Assets Acquired, the
Liabilities Assumed, and Any
Noncontrolling Interest in the Acquiree
Detailed Contents
Recognition Principle*
Recognition Conditions
Assets and Liabilities: Concepts Statement 6
Example 7.1: Substantive Obligation of the Acquiree
Transactions That Are Not a Part of the Business Combination Transaction
(Separate Transactions)
Classifying and Designating Identifiable Assets Acquired and Liabilities Assumed
Classification Principle
Exceptions to the Classification Principle
(Pre-ASC Topic 842) Classification of Leases
(ASC Topic 842) Classification of Leases
Classification of Insurance and Reinsurance Contracts
Accounting Policies Applicable to the Assets Acquired and Liabilities Assumed
Recognizing Particular Assets Acquired and Liabilities Assumed
(ASC Topic 606) Contract Assets and Contract Liabilities
Example 7.1a: Contract Assets for an Acquisition Occurring prior to ASC Topic
606 Adoption
(ASC Subtopic 340-40) Contract Cost Assets
Liabilities Associated with Restructuring or Exit Activities of the Acquiree
Restructuring or Exit Activities of the Acquirer and Integration Costs an Acquirer
Expects to Incur as a Result of an Acquisition
Restructuring and Exit Activities of the Acquirer
Integration Costs the Acquirer Expects to Incur
Example 7.2: Costs to Prepare Acquired Equipment for Its Intended Use
Recognition of Prepayment Penalties Associated with Debt Assumed in a Business
Combination
(ASC Topic 842) Lease Contracts
(Pre-ASC Topic 842) Lease Contracts
(Pre-ASC Topic 842) Classification of Leases Acquired in a Business
Combination
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
(Pre-ASC Topic 842) Summary of Assets and Liabilities Arising from Lease
Contracts of an Acquiree Recognized by the Acquirer in a Business
Combination
(Pre-ASC Topic 842) In-Place Leases
(Pre-ASC Topic 842) Favorable or Unfavorable Lease Contract Terms
Example 7.3: Contingent Rental Provisions in an Operating Lease
(Pre-ASC Topic 842) Presentation of Assets and Liabilities for Favorable or
Unfavorable Operating Lease Contracts Acquired in a Business Combination
(Pre-ASC Topic 842) Customer Relationships and Other Identifiable Intangible
Assets Associated with Lease Contracts
Example 7.4: Airport Gate Operating Lease
(Pre-ASC Topic 842) Assets Subject to Operating Leases When the Acquiree Is
the Lessor
Example 7.5: Operating Lease of an Acquiree as the Lessor
(Pre-ASC Topic 842) Assets Subject to Operating Leases When the Acquiree Is
the Lessee
(Pre-ASC Topic 842) Prepaid or Accrued Rent Recognized by an Acquiree on
Operating Leases
Example 7.6: Prepaid or Accrued Rent Recognized by an Acquiree on Operating
Leases
(Pre-ASC Topic 842) Capital Lease Contracts of an Acquiree
(Pre-ASC Topic 842) Leasehold and Tenant Improvements
(Pre-ASC Topic 842) Sales-Type and Direct Financing Leases
(Pre-ASC Topic 842) Leveraged Leases
(Pre-ASC Topic 842) Additional Considerations Related to Lease Contracts
Involvement of a Third-Party Lessor in a Business Combination (pre-Topic 842)
Recognition of Intangible Assets Separately from Goodwill--Public Business Entities
Contractual-Legal Criterion
Separability Criterion
Example 7.7: Depositor Relationships
Example 7.8: Registered Trademarks
Items That Are Not Identifiable
Illustrative List of Intangible Assets That Are Identifiable
Marketing-Related Intangible Assets
Customer-Related Intangible Assets
Example 7.9: Order Backlog
Example 7.10: Customer Relationships (No Existing Contracts)
Example 7.11: Customer Relationships—Contractual-Legal Criterion
Example 7.12: Customer Relationships—More Than One Relationship with a
Single Customer
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
Example 7.13: Customer Relationships—Contractual-Legal Criterion
Example 7.14: Customer Relationships Not Recognized (Contractual-Legal
Criterion Not Met) and Customer List Not Recognized Due to Confidentiality
Restrictions)
Example 7.15: Customer Relationships—Overlapping Customer Relationships –
Scenario 1
Example 7.16: Customer Relationships—Overlapping Customer Relationships –
Scenario 2
Example 7.17: Acquiree’s Preexisting Customer Relationship With Acquirer Is
Not Recognized as a Customer Relationship Intangible Asset by the Acquirer
Q&A 7.0: Customer Relationships - Healthcare Patient Relationships
Artistic-Related Intangible Assets
Contract-Based Intangible Assets
Example 7.18: Supply Contracts
Technology-Based Intangible Assets
Research And Development Assets
Example 7.19: Activities That Typically Would Be Included in Research and
Development Activities
Example 7.20: Activities That Typically Would Be Excluded from Research and
Development Activities
In-Process Research And Development Activities
Q&A 7.1: Initial Measurement – IPR&D in a Development Arrangement
Q&A 7.2: Subsequent Measurement – IPR&D in a Development Arrangement
Example 7.21: The IPR&D Guide Q&A, par. 2.60: Specific R&D Projects –
Incompleteness
Example 7.22: The IPR&D Guide Q&A, par. 2.61: Specific R&D Projects –
Incompleteness
Example 7.23: The IPR&D Guide Q&A, par. 2,62: Specific R&D Projects –
Incompleteness
Example 7.24: The IPR&D Guide Q&A, par. 2.63: Specific R&D Projects –
Incompleteness
Example 7.25: The IPR&D Guide Q&A, par. 2.51: Specific R&D Projects –
Substance
Example 7.26: The IPR&D Guide Q&A, par. 2.52: Specific R&D Projects –
Substance
Example 7.27: The IPR&D Guide Q&A par. 2.53: Specific R&D Projects –
Substance
Considerations for Financial Services Entities – Customer-Related Intangible
Assets
Recognizing Any Noncontrolling Interest in an Acquiree
Example 7.28: Recognizing Noncontrolling Interest at Fair Value
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
Measurement Principle4
Application Guidance Related to Measuring the Fair Values of Particular Identifiable
Assets and a Noncontrolling Interest in an Acquiree
Assets with Uncertain Cash Flows (Valuation Allowances)
Example 7.29: Acquired Trade Receivables – Valuation Allowance
(Pre-ASC Topic 842) Assets Subject to Operating Leases in which the Acquiree Is the
Lessor
Assets That the Acquirer Intends Not to Use or to Use in a Way Other Than Their
Highest and Best Use
Example 7.30: Acquirer Does Not Intend to Use Acquired Trade Name
Example 7.31: Acquired IPR&D the Acquirer Does Not Intend to Use
Contingent Consideration Arrangements of an Acquiree Assumed by the Acquirer
Measuring the Fair Value of a Noncontrolling Interest in an Acquiree
Exceptions to the Recognition and Measurement Principles (Pre-ASC Topic 842)
Exceptions to Both the Recognition and Measurement Principles
Assets and Liabilities Arising from Contingencies
Deferred Tax Assets and Liabilities and Tax Uncertainties
Employee Benefits
Example 7.32: Funded Status of a Single-Employer Defined Benefit Pension Plan
of an Acquiree before and after a Business Combination
Example 7.33: Plan Amendments an Acquirer Is Not Required to Make
Example 7.34: Employees of Acquiree Included in Pension Plan of Acquirer
Example 7.35: Postretirement Benefit Plan That Will Be Amended as a Condition
of the Acquisition Agreement
Indemnification Assets
Example 7.36: Indemnification Asset Related to Noncontractual Contingency
Exceptions to the Measurement Principle
Reacquired Rights
Example 7.37: Reacquired Right
Share-Based Payment Awards
Assets Held for Sale
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164
7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
7.000 ASC Topic 805, Business Combinations, requires an acquirer to recognize,
separately from goodwill, the identifiable assets acquired, liabilities assumed, and any
noncontrolling interest in the acquiree, and to measure these items at their acquisition-
date fair values, with limited exceptions. ASC Topic 805 does not provide guidance on
how to measure fair value, but instead refers to the fair value measurement requirements
of ASC Subtopic 820-10, Fair Value Measurement - Overall. ASC Subtopic 820-10
defines fair value, establishes a framework for measuring fair value, and establishes
disclosure requirements related to fair value measurements.
7.001 This Section provides guidance on the recognition and measurement of the assets
acquired, liabilities assumed, and any noncontrolling interest in the acquiree, including
those subject to the exceptions to the fair value measurement principle. Sections 16
through 21 on Fair Value Measurements provide additional guidance on the estimation of
the fair value of assets acquired, liabilities assumed, and any noncontrolling interest in
the acquiree.
7.002 Subsequent measurement and accounting for assets acquired, liabilities assumed or
incurred, and equity instruments issued in a business combination are based on other
applicable GAAP. However, ASC Topic 805 does provide guidance on the subsequent
measurement and accounting for certain assets acquired, liabilities assumed or incurred,
and equity instruments issued in a business combination. See Section 12 for a discussion
of Subsequent Measurement and Accounting.
RECOGNITION PRINCIPLE*
ASC Paragraph 805-20-25-1
As of the acquisition date, the acquirer shall recognize, separately from goodwill,
the identifiable assets acquired, the liabilities assumed, and any noncontrolling
interest in the acquiree. Recognition of identifiable assets acquired and liabilities
assumed is subject to the conditions specified in [ASC] paragraphs 805-20-25-2
through 25-3. However, an entity (the acquirer) within the scope of ASC
paragraph 805-20-15-2 may elect to apply the accounting alternative for the
recognition of identifiable intangible assets acquired in a business combination as
described in ASC paragraphs 805-20-25-29 through 25-33.
* See discussion of exceptions to this principle in this Section under Exceptions to Both the Recognition
and Measurement Principles. These exceptions relate to assets and liabilities arising from contingencies,
deferred tax assets and liabilities and uncertain tax positions, indemnification assets, employee benefits,
reacquired rights, share-based payment awards, and assets held for sale. In addition, Section 26, Private
Company and Not-for-Profit Accounting Alternatives, discusses additional exceptions for private
companies and not-for-profit entities.
RECOGNITION CONDITIONS
ASC Paragraph 805-20-25-2
To qualify for recognition as part of applying the acquisition method, the
identifiable assets acquired and liabilities assumed must meet the definitions of
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
assets and liabilities in FASB Concepts Statement No. 6, Elements of Financial
Statements, at the acquisition date. For example, costs the acquirer expects but is
not obligated to incur in the future to effect its plan to exit an activity of an
acquiree or to terminate the employment of or relocate an acquiree’s employees
are not liabilities at the acquisition date. Therefore, the acquirer does not
recognize those costs as part of applying the acquisition method. Instead, the
acquirer recognizes those costs in its postcombination financial statements in
accordance with other applicable generally accepted accounting principles
(GAAP).
ASC Paragraph 805-20-25-3
In addition, to qualify for recognition as part of applying the acquisition method,
the identifiable assets acquired and liabilities assumed must be part of what the
acquirer and the acquiree (or its former owners) exchanged in the business
combination transaction rather than the result of separate transactions. The
acquirer shall apply the guidance in [ASC] paragraphs 805-10-25-20 through 25-
23 to determine which assets acquired or liabilities assumed are part of the
exchange for the acquiree and which, if any, are the result of separate transactions
to be accounted for in accordance with their nature and the applicable GAAP.
7.003 Two conditions are required to be met before identifiable assets acquired and
liabilities assumed can be recognized in a business combination. These conditions state
that identifiable assets acquired and liabilities assumed:
• Meet the definitions of assets and liabilities in Concepts Statement 6 at the
acquisition date; and
• Are part of what the acquirer and acquiree (or its former owners) exchanged
in the business combination rather than the result of separate transactions. See
the discussion of Determining What Is Part of the Business Combination
Transaction in Section 11.
7.004 See the discussion of Exceptions to Both the Recognition and Measurement
Principles.
Assets and Liabilities: Concepts Statement 6
7.005 Concepts Statement 6 defines assets as “probable future economic benefits
obtained or controlled by a particular entity as a result of past transactions or events”
(Concepts Statement 6, par. 25) and liabilities as “probable future sacrifices of economic
benefits arising from present obligations of a particular entity to transfer assets or provide
services to other entities in the future as a result of past transactions or events” (Concepts
Statement 6, par. 35). A footnote to paragraph 35 of Concepts Statement 6 provides
additional clarification of the meaning of obligations: “Obligations in the definition is
broader than legal obligations. It is used with its usual general meaning to refer to duties
imposed legally or socially; to that which one is bound to do by contract, promise, moral
responsibility, and so forth. It includes equitable and constructive obligations as well as
legal obligations.”
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
7.006 Applying the recognition provisions of ASC Topic 805 may result in the acquirer
recognizing some assets and liabilities that the acquiree had previously not recognized as
assets and liabilities in its financial statements. For example, the acquirer would
recognize the acquired identifiable intangible assets such as in-process research and
development, brand names, patents, and customer relationships, even if the acquiree did
not recognize these assets because they were developed internally and the related costs
were charged to expense.
7.007 Under ASC Topic 805, transaction costs for services received in connection with a
business combination, such as legal fees, other professional and consulting fees, and due
diligence fees, would not be considered an asset acquired at the date of acquisition and
are not part of the fair value of the consideration transferred to the seller. Those costs
would be expensed as incurred, unless they are costs related to the issuance of debt or
equity instruments, in which case they are accounted for under applicable GAAP. (ASC
paragraph 805-20-25-2; Statement 141(R), par. B114) See discussion of Acquisition-
Related Costs and Other Payments to an Acquiree (or its Former Owners) That Are Not
Part of the Consideration Transferred in Section 11.
7.008 For guidance on presenting transaction costs in the statement of cash flows, see
chapter 18 of KPMG Handbook, Statement of cash flows.
7.009 Expected Restructuring Costs. Under Concepts Statement 6, an example of costs
that do not meet the definition of a liability assumed at the acquisition date is expected
restructuring costs. An acquirer recognizes liabilities for restructuring or exit activities of
the acquiree as part of the accounting for a business combination under ASC Topic 805
only if they meet the definition of liabilities under Concepts Statement 6 at the
acquisition date. Costs the acquirer expects, but is not obligated, to incur in the future are
not liabilities at the acquisition date and are not accounted for as part of the business
combination. See the discussion of Liabilities Associated with Restructuring or Exit
Activities of the Acquiree.
7.010 (Pre-ASC Topic 6061) Deferred Revenue of an Acquiree Where There Is No
Legal Performance Obligation. An example of an item that does not meet the definition
of a liability under Concepts Statement 6 (and would not be recognized by the acquirer in
accounting for the acquisition under ASC Topic 805 is deferred revenue recognized by an
acquiree where there is no legal performance obligation assumed by the acquirer (such as
a legal obligation to provide goods, services, the right to use an asset, or other
consideration to customers). An acquiree may have delivered all goods or services under
an arrangement with a customer in exchange for a promissory note, but may have
deferred revenue recognition because collectibility of the note was not reasonably
assured. The deferred revenue does not relate to a legal performance obligation, and the
acquirer would not recognize a liability in its accounting for the acquisition. However,
the promissory note would be recognized at its fair value, which would reflect an
assessment of the note’s collectibility.
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167
7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
7.011 (Pre-ASC Topic 842) Prepaid or Accrued Rent Recognized by an Acquiree on
Operating Leases. Another example of an item that may not meet the definition of an
asset or a liability under Concepts Statement 6 is prepaid or accrued rent related to an
operating lease that was recognized by an acquiree (as required under ASC paragraph
840-20-25-2) before its acquisition. See discussion of Prepaid or Accrued Rent
Recognized by an Acquiree on Operating Leases under Lease Contracts in this Section.
7.011a (ASC Topic 842) Prepaid or Accrued Rent Recognized by an Acquiree on
Operating Leases. For guidance on accounting for prepaid or accrued rent in a business
combination after adopting ASC Topic 842, see chapter 11 of KPMG Handbook, Leases.
7.012 Substantive Obligations of an Acquiree. An acquiree may have recognized a
liability for a substantive obligation. If the acquirer concludes that there is a substantive
obligation and assumes that obligation, the acquirer should recognize a liability for the
substantive obligation at its acquisition-date fair value.
Example 7.1: Substantive Obligation of the Acquiree
ABC Corp. acquires DEF Corp. in a business combination. DEF had a widely published
policy that it historically honored product defects after the warranty expiration period,
and determined that it had a substantive obligation to continue its historical practice and
recorded a liability related to this historical practice before its acquisition by ABC. ABC
reviewed this matter in connection with its accounting for the acquisition of DEF, and
also concluded that DEF had a substantive obligation to continue its historical practice.
ABC will therefore recognize a liability for DEF’s substantive obligation at the
acquisition date, measured at fair value, because the obligation falls within the definition
of a liability in Concepts Statement 6.
Transactions That Are Not a Part of the Business Combination Transaction
(Separate Transactions)
7.013 Amounts that are not part of what the acquirer and the acquiree (or its former
owners) exchanged in a business combination are not recognized as assets acquired or
liabilities assumed in the business combination. For example, amounts related to the
settlement of preexisting relationships between an acquirer and an acquiree, a transaction
that compensates employees or former owners of the acquiree for future services, and a
transaction that reimburses the acquiree or its former owners for paying the acquirer’s
acquisition-related costs are not part of the accounting for the acquisition, but rather are
accounted for as separate transactions based on other relevant GAAP. See the discussion
of Determining What Is Part of the Business Combination Transaction in Section 11.
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
CLASSIFYING AND DESIGNATING IDENTIFIABLE ASSETS
ACQUIRED AND LIABILITIES ASSUMED
CLASSIFICATION PRINCIPLE
ASC Paragraph 805-20-25-6
At the acquisition date, the acquirer shall classify or designate the identifiable
assets acquired and liabilities assumed as necessary to subsequently apply other
GAAP. The acquirer shall make those classifications or designations on the basis
of the contractual terms, economic conditions, its operating or accounting
policies, and other pertinent conditions as they exist at the acquisition date.
7.014 The accounting for a particular asset or liability subsequent to an acquisition may
differ depending on how it is classified or designated. ASC Topic 805 requires the
acquirer to classify and designate assets acquired and liabilities assumed in an acquisition
at the acquisition date as required to enable it to apply other GAAP, based on the
contractual terms, economic conditions, the acquirer’s accounting policies, and other
pertinent conditions at the acquisition date. ASC paragraph 805-20-25-7 provides three
examples of classifications required to be made by the acquirer at the acquisition date:
a. Classification of particular investments in securities as trading, available for
sale, or held to maturity in accordance with ASC Section 320-10-25;
b. Designation of a derivative instrument as a hedging instrument in accordance
with ASC paragraph 815-10-05-4; and
c. Assessment of whether an embedded derivative should be separated from the
host contract in accordance with ASC Section 815-15-25 (which is a matter of
classification as used in ASC Subtopic 805-20).
7.015 The above examples are not all-inclusive. For example:
• Long-Lived Assets or Disposal Groups. An acquirer may intend, at the
acquisition date, to dispose of a long-lived asset (or disposal group) of the
acquiree. In these instances, the acquirer would follow the guidance in ASC
paragraphs 360-10-35-37 through 35-43 and 45-9 through 45-14 in
determining the classification and presentation of the long-lived asset (or
disposal group) in the acquirer’s postcombination consolidated financial
statements.
• Fair Value Option. The acquirer may elect the fair value option for eligible
items included in the assets acquired or liabilities assumed in a business
combination. The classification of and subsequent accounting for these items
are determined in accordance with ASC paragraphs 825-10-15-3 through 15-7
and 25-4.
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
EXCEPTIONS TO THE CLASSIFICATION PRINCIPLE
7.016 ASC Topic 805 includes two exceptions to the principle discussed above in
classifying or designating assets acquired and liabilities assumed where the acquiree
classification is retained. Those exceptions are (a) classification of a lease contract as
either an operating lease or a capital lease under either ASC Topic 840, Leases, or ASC
Topic 842, Leases, and (b) classification of a contract written by an entity that is in the
scope of ASC Topic 944, Financial Services—Insurance. ASC paragraph 805-20-25-8
(Pre-ASC Topic 842) Classification of Leases
7.017 ASC Topic 805 retains the guidance in ASC Subtopic 840-10 which specifies that
lease contracts assumed by an acquirer in a business combination should be classified on
the basis of the contractual terms and other factors at the inception of the contract (or, if
the terms of the contract have been modified in a manner that would change its
classification, at the date of that modification, which might be the acquisition date). (ASC
paragraph 805-20-25-8) See Classification of Leases Acquired in a Business
Combination and Leveraged Leases under the discussion of Lease Contracts in this
Section.
7.018 A lease agreement may be modified to reflect a change in the identity of one of the
parties to the agreement, as a result of a business combination. Such changes are not
modifications of the provisions of the lease agreement for this purpose and do not affect
the classification of the lease. The acquirer has simply purchased an interest in a lease
agreement previously entered into by two other parties.
7.019 At the acquisition date, the acquirer may contemplate renegotiating and modifying
leases of the business acquired. Modifications made after the acquisition date, including
those that were planned at the time of the business combination, are postcombination
events that should be accounted for separately by the acquirer in accordance with the
provisions of ASC Topic 840. ASC paragraph 840-10-35-5
(ASC Topic 842) Classification of Leases
7.019a For guidance on classifying an assumed lease after adopting ASC Topic 842, see
chapter 11 of KPMG Handbook, Leases.
Classification of Insurance and Reinsurance Contracts
7.020 ASC Topic 805 amended ASC Topic 944 to require the acquirer to classify
contracts within the scope of ASC Topic 944 on the basis of the contractual terms and
other factors at the inception of the contract (or the modification date). As a result, the
acquirer carries forward the acquiree’s classification of an acquired contract as an
insurance or reinsurance contract or a deposit contract based on an understanding of the
contractual terms of the acquired contract and any related contracts or agreements at the
inception of the contract or, if the terms of those contracts or agreements were later
modified in a manner that would change the classification, at the date of that modification
(which may be the acquisition date).
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
7.021 While the insurance contracts retain the acquiree's classification, the liability is
measured at fair value at the acquisition date and accounted for in two components based
on the guidance in ASC paragraph 944-805-30-1. First, assets and liabilities are measured
using the acquirer's accounting policies for insurance and reinsurance contracts it issues
or holds. For example, the contractual assets acquired could include a reinsurance
recoverable and the liabilities assumed could include a liability to pay future contract
claims and claims expenses on the unexpired portion of the acquired contracts, and a
liability to pay incurred contract claims and claims expenses. However, the assets
acquired and liabilities assumed would not include the acquiree's deferred acquisition
costs and unearned premiums that do not represent future cash flows. The second
component would be an intangible asset (or occasionally another liability), representing
the difference between the fair value of the contractual insurance and reinsurance assets
acquired and liabilities assumed and the amount determined in the first step. The
intangible asset may be presented as one caption in the statement of financial position in
accordance with ASC paragraph 944-805-30-1.
7.022 The assumptions used to compute the first component are established and locked in
for post-acquisition accounting using current assumptions as of the date of the business
combination.
7.023 Other related contracts that are not insurance or reinsurance contracts are measured
at the acquisition date in accordance with the guidance in ASC Topic 805, generally at
fair value. For example, an employer's workers' compensation liability is measured at fair
value in acquisition accounting rather than at an undiscounted amount, even if the
acquiree's pre-acquisition policy had been to record the workers' compensation liability at
an undiscounted amount.
ACCOUNTING POLICIES APPLICABLE TO THE ASSETS
ACQUIRED AND LIABILITIES ASSUMED
7.024 See Paragraph 12.030 for discussion of accounting policies applicable to assets
acquired and liabilities assumed.
RECOGNIZING PARTICULAR ASSETS ACQUIRED AND
LIABILITIES ASSUMED
7.025 This section discusses recognition considerations related to certain assets acquired
and liabilities assumed in a business combination. The following sections discuss
measurement considerations and the exceptions to the recognition and measurement
principles.
(ASC TOPIC 606) CONTRACT ASSETS AND CONTRACT LIABILITIES
7.025a A contract asset represents the right to consideration from the performance of the
acquiree under a customer contract as of the acquisition date. It is distinguished from a
trade receivable because it is conditional on something other than the passage of time. A
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
contract asset is recognized at its acquisition date fair value. For further discussion of
contract assets, see paragraph 17.084d.
Example 7.1a: Contract Assets for an Acquisition Occurring prior to ASC
Topic 606 Adoption
Entity Z acquired Business Software Corp. on September 15, 2015. Entity Z adopts Topic
606 on January 1, 2018 using the full retrospective transition approach. Entity Z is an
SEC registrant and recasts its financial statements for the years ended December 31, 2017
and 2016 and records a transition adjustment as of January 1, 2016.
Business Software enters into agreements with its customers to provide up to 2-year term
licenses that are bundled with coterminous maintenance, for a fixed fee paid in monthly
installments. Before adopting Topic 606, Business Software recognized license and
maintenance revenue ratably as a single deliverable over the term of the maintenance as
the payments came due. Under Topic 606, the promised goods and services - the software
license and maintenance - are determined to be distinct and therefore accounted for as
separate performance obligations. The portion of the transaction price allocated to the
license is recognized at a point in time on initial delivery of the software, while the
portion of the transaction price allocated to the maintenance is recognized ratably over
the contract term.
While calculating the transition adjustment, Entity Z notes that some of Business
Software's revenue recognized in Entity Z's 2016 and 2017 consolidated financial
statements would have been recognized under Topic 606 before the acquisition date.
Ordinarily, under Topic 606, the cash flows received in 2016 and 2017 related to the
license would be credited against a contract asset that would have been recognized on
delivery of the license. However, Entity Z did not record a contract asset in its historical
acquisition accounting.
Entity Z notes that the post-acquisition cash flows associated with pre-acquisition
software license arrangements were included in the cash flow forecast used to value the
customer relationship intangible at the acquisition date. As such, a portion of the
customer relationship intangible asset relates to the cash flows attributable to licenses
sold before the acquisition date.
Entity Z concludes that, as part of adopting Topic 606, it should recast its accounting for
the 2015 business combination to reclassify a portion of the customer relationship
intangible as a separate contract asset (measured at the acquisition date fair value and
rolled forward to January 1, 2016) to align the acquired assets with the corresponding
post-acquisition cash flows associated with the Topic 606 performance obligations. The
adjustment results in an increase to a contract asset and an offsetting decrease to customer
relationship intangible in the acquisition accounting, as well as a corresponding decrease
in post-acquisition amortization expense over the useful life of the customer relationship
intangible. This approach results in no adjustment to goodwill recorded in the acquisition
and allows Entity Z to properly account for Business Software's post-acquisition software
license cash collections under Topic 606.
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
7.025b A contract liability is an obligation to transfer goods or services to a customer for
which the acquiree has either received consideration or has an unconditional right to
payment under a non-cancellable contract with a customer. For further discussion of
contract liabilities, see paragraph 17.084f.
7.025c As ASC Topic 606 specifies that contract assets and contract liabilities for a
single contract are presented on a net basis, we believe the unit of account for recognition
and measurement of contract assets and liabilities in a business combination is also at the
contract level.
(ASC SUBTOPIC 340-40) CONTRACT COST ASSETS
7.025d Under ASC Subtopic 340-40, Other Assets and Deferred Costs -- Contracts with
Customers, certain costs related to a contract with a customer are deferred and recognized
as an asset. These costs may relate to incremental costs of obtaining a contract or certain
costs to fulfill a contract. We believe the acquirer would not recognize an asset for such
costs similar to debt issuance costs or deferred acquisition costs for insurance contracts.
Instead, any fair value attributed to the acquired customer contracts would be included in
the fair value of the customer-related intangible assets (see Paragraphs 7.085 through
7.093).
LIABILITIES ASSOCIATED WITH RESTRUCTURING OR EXIT ACTIVITIES OF THE
ACQUIREE
7.026 Before the effective date of ASC Topic 805, EITF Issue No. 95-3, “Recognition of
Liabilities in Connection with a Purchase Business Combination,” specified that costs
associated with an acquirer’s plan to (a) exit an activity of an acquiree, (b) involuntarily
terminate employees of an acquiree, or (c) relocate employees of an acquiree, should be
recognized as liabilities assumed in a business combination if specified conditions were
met.
7.027 However, in deliberating ASC Topic 805, the FASB noted that an exit or disposal
plan by itself does not create a present obligation and that an entity’s commitment to such
a plan is not a sufficient condition for recognition of a liability. Accordingly, ASC Topic
805 nullified EITF 95-3. Under ASC Topic 805, an acquirer recognizes liabilities related
to restructuring and exit activities of the acquiree only if they represent an existing
substantive liability of the acquiree at the acquisition date and the acquiree has little or no
discretion to avoid a settlement of the liability. For restructuring and exit activities of the
acquiree that the acquirer initiates, the acquirer incurs a liability associated with the costs
only after it gains control of the acquiree’s business. ASC paragraph 805-20-25-2;
Statement 141(R), pars. B132-133
7.028 Thus, an acquirer only recognizes the acquisition-date fair value of a liability
associated with exit or disposal activities of the acquiree as part of a business
combination if those costs meet the criteria for recognition under ASC Subtopic 420-10,
Exit or Disposal Cost Obligations - Overall, as of the acquisition date.
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
7.029 If an exit or disposal activity is undertaken by an acquiree shortly before the date of
acquisition, consideration should be given to whether the activity should be accounted for
as part of the business combination, or as a separate transaction. If the exit or disposal
activity is undertaken at the request of, and for the benefit of, the acquirer, the activity is
not a part of the business combination and should be accounted for as a separate
transaction.
7.030 An acquiree may undertake an exit or disposal activity that will be implemented
only if a planned business combination occurs. ASC paragraphs 805-20-55-50 through
55-51 indicate that, if a company that has agreed to a business combination develops a
plan to terminate certain employees, but the plan will be implemented only if the
combination is consummated, a liability for the contractual termination benefits and the
curtailment losses under employee benefit plans that will be triggered by the
consummation of the business combination should be recognized only when the business
combination is consummated, even if consummation is probable at an earlier date. If the
activity was undertaken at the request of the acquirer or was designed primarily for the
economic benefit of the acquirer or the combined entity following the acquisition, the
associated costs would not be a part of the accounting for the business combination and
no liability would be recorded at the acquisition date. Instead, the activity would be
accounted for as a separate transaction. See the discussion of Determining What Is Part
of the Business Combination Transaction in Section 11.
RESTRUCTURING OR EXIT ACTIVITIES OF THE ACQUIRER AND INTEGRATION
COSTS AN ACQUIRER EXPECTS TO INCUR AS A RESULT OF AN ACQUISITION
Restructuring and Exit Activities of the Acquirer
7.031 An acquirer may expect to incur costs associated with restructuring or exit
activities related to its preexisting operations as a result of an acquisition. These costs are
not liabilities of the acquiree, and are not part of the accounting for the acquisition.
Rather, such costs are accounted for in accordance with other applicable GAAP including
but not limited to ASC paragraphs 715-30-25-8 through 25-13, ASC Subtopics 712-10
and 420-10.
Integration Costs the Acquirer Expects to Incur
7.032 Costs an acquirer expects to incur to integrate the activities of an acquiree into the
acquirer’s operations are neither liabilities of the acquiree nor part of the accounting for
the acquisition. The combined entity would capitalize or expense these costs in its
postcombination financial statements, based on the nature of the item and the acquirer’s
accounting policy for the costs. However, plans to incur certain integration costs may
affect the determination of the fair value of assets of the acquired entity. If market
participants would be expected to incur integration costs with respect to an asset acquired
in a business combination, then the fair value of the asset would be determined giving
consideration to such expectation. For example, if market participants would be expected
to relocate specialized manufacturing activities of an acquiree to reduce freight costs,
then the anticipated costs of relocating the specialized equipment used in the
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
manufacturing process would be considered in determining the fair value of the
machinery and equipment.
7.033 Examples of planned integration costs that would not be liabilities of an acquiree
and would not be recognized in the accounting for the acquisition, but depending on the
facts and circumstances, may be capitalized in the postcombination financial statements
of the combined entity based on the acquirer’s accounting policy for such costs, if they
extend the useful life or enhance the service potential of the related assets, are:
• Costs to purchase new signs with the acquirer’s logo to replace acquiree’s
existing signs;
• Costs to upgrade the acquiree’s plant or store locations to meet specifications
of the acquirer;
• Costs to upgrade the acquiree’s computer software and hardware; and
• Costs to purchase new computers for the acquiree’s location.
Example 7.2: Costs to Prepare Acquired Equipment for Its Intended Use
ABC Corp., a company involved in the mining industry, acquires DEF Corp. in a
business combination. The assets acquired from DEF include mining equipment located
in an abandoned mine in a remote location. There is no expectation that the mine will be
reopened, nor is there a reasonable prospect that a market participant could use the
equipment in the immediate surrounding area. ABC decided that, following the
acquisition, it will dismantle the acquired mining equipment and transport it to one of its
existing mining properties, where it will use the equipment together with existing mining
equipment to increase output and lower extraction costs. ABC has also determined that
other market participants would dismantle the mining equipment and employ it in a
similar manner at mining activities in other locations.
In applying the acquisition method to this transaction, ABC recognizes the mining
equipment as an asset, measured at its acquisition-date fair value. The acquisition-date
fair value of the equipment might be determined based on observed prices for similar
equipment, adjusted for dismantling costs, and differentials in the condition and location
of the equipment and installation costs, such that the fair value measurement reflects the
current condition and location of the equipment. The cost of dismantling, overhauling and
reconditioning, relocating, and reassembling the mining equipment is not a liability at the
acquisition date, and thus is not part of the accounting for the acquisition.
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
7.034 Examples of integration costs that would not be liabilities of an acquiree and would
not be recognized in the accounting for the acquisition, and would be expensed as
incurred are:
• Consulting fees to identify combined entity goals; and
• Advertising costs for a program to announce the acquisition or to promote the
combined entity.
RECOGNITION OF PREPAYMENT PENALTIES ASSOCIATED WITH DEBT
ASSUMED IN A BUSINESS COMBINATION
7.035 An acquirer recognizes a liability equal to the acquisition-date fair value of the
acquiree’s debt legally assumed by the acquirer as part of the acquisition. If the debt’s
terms require it to be extinguished as part of or immediately following a business
combination, for example because of a change-in-control provision included in the debt
agreement, the fair value of the debt should be determined giving consideration to the
contractual provision of the debt agreement requiring prepayment in the event of a
change-in-control. If the acquirer does not legally assume the acquiree's debt as part of
the business combination and the debt is extinguished on the acquisition date, any funds
provided by the acquirer to fund the extinguishment of the acquiree's debt should be
reflected by the acquirer as consideration transferred. For guidance on presenting
payments to extinguish an acquiree's debt in the statement of cash flows, see chapter 18
of KPMG Handbook, Statement of cash flows. See Section 17 for a discussion of the fair
value measurement of debt assumed by the acquirer in a business combination.
(ASC TOPIC 842) LEASE CONTRACTS
7.035a ASU 2016-02, Leases, changes certain aspects of accounting for leases acquired
in a business combination. The ASU is effective for public business entities, certain not-
for-profit entities, and certain employee benefit plans for annual and interim periods in
fiscal years beginning after December 15, 2018. For not-for-profit entities that have
issued or are conduit bond obligors for securities that are traded, listed, or quoted on an
exchange or an over-the-counter market that have not yet issued financial statements or
made financial statements available for issuance as of June 3, 2020, it is effective for
annual and interim periods in fiscal years beginning after December 15, 2019. For all
other entities, the ASU is effective for annual periods in fiscal years beginning after
December 15, 2021, and interim periods in fiscal years beginning after December 15,
2022. Early adoption is permitted. For guidance on accounting for lease contracts
assumed in a business combination after an acquirer has adopted ASC Topic 842, see
chapter 11 of KPMG Handbook, Leases. The guidance in this section addresses
accounting for leases assumed in a business combination before an acquirer has adopted
ASC Topic 842.
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
(PRE-ASC TOPIC 842) LEASE CONTRACTS
7.036 Entities enter into lease agreements as the lessor or lessee as part of their normal
operations. This section provides recognition and measurement guidance associated with
assets and liabilities typically arising from lease contracts. See Section 17 for guidance on
the fair value measurement of assets and liabilities arising from lease contracts acquired
or assumed in a business combination.
7.037 ASC Topic 840 establishes standards of financial accounting and reporting for
leases by lessees and lessors. ASC Subtopic 840-10 describes a lease as:
ASC Master Glossary: Lease
An agreement conveying the right to use property, plant, or equipment (land
and/or depreciable assets) usually for a stated period of time.
ASC Paragraph 840-10-15-9
This [ASC] Topic also includes agreements that, although not nominally
identified as leases, meet the definition of a lease, such as a heat supply contract
for nuclear fuel.
ASC Paragraph 840-10-15-10
The definition of a lease does not include agreements that are contracts for
services that do not transfer the right to use property, plant, or equipment from
one contracting party to the other. Further, although specific property, plant, or
equipment may be explicitly identified in an arrangement, it is not the subject of a
lease if fulfillment of the arrangement is not dependent on the use of the specified
property, plant, or equipment.
ASC Paragraph 840-10-15-8
Agreements that transfer the right to use property, plant, or equipment meet the
definition of a lease for purposes of this [ASC] Topic even though substantial
services by the contractor (lessor) may be called for in connection with the
operation or maintenance of such assets.
ASC Paragraph 840-10-15-15
Because a lease is defined as conveying the right to use property, plant, or
equipment (land and/or depreciable assets), inventory (including equipment parts
inventory) and minerals, precious metals, or other natural resources cannot be the
subject of a lease for accounting purposes because those assets are not
depreciable. This [ASC] Topic does not apply to lease agreements concerning the
rights to explore for or to exploit natural resources such as oil, gas, minerals,
timber, precious metals, or other nature resources. Similarly, intangibles such as
workforce and licensing agreements for items such as motion picture films, plays,
manuscripts, patents, and copyrights are not deemed the subject of a lease for
accounting purposes even though those assets may be amortized.
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
7.038 If the arrangement conveys to the purchaser (lessee) the right to control the use of
the underlying property, plant, or equipment, that arrangement conveys the right to use
the property, plant, or equipment. See ASC paragraph 840-10-15-6 for additional
guidance in determining whether an arrangement includes a lease.
(Pre-ASC Topic 842) Classification of Leases Acquired in a Business Combination
7.039 ASC Topic 805 generally requires that the assets acquired and liabilities assumed
in an acquisition be classified or designated by the acquirer based on the contractual
terms, economic conditions, the acquirer’s operating or accounting policies, and other
pertinent conditions as they exist at the acquisition date. See discussion of Classifying
and Designating Identifiable Assets Acquired and Liabilities Assumed in this Section. In
an exception to this requirement, ASC Topic 805 specifies that lease contracts assumed
by an acquirer in a business combination should be classified (as a capital or operating
lease) on the basis of the contractual terms and other factors at the inception of the
contract (or, if the terms of the contract have been modified in a manner that would
change its classification, at the date of that modification, which might be the acquisition
date). (ASC paragraph 805-20-25-8) This is consistent with the guidance previously
included in FIN 21, Accounting for Leases in a Business Combination (now ASC
paragraph 840-10-35-5). If the provisions of the lease agreement are modified in
connection with a business combination in a way that would require the revised
agreement to be considered a new agreement under ASC paragraph 840-10-35-4, the
lease should be classified by the acquirer at the acquisition date in accordance with the
criteria in ASC Topic 840.
7.040 As discussed in Exceptions to the Classification Principle, a lease agreement may
be modified to reflect a change in the identity of one of the parties to the agreement as a
result of a business combination. Such changes are not modifications of the provisions of
the lease agreement for this purpose and do not affect the classification of the lease. The
acquirer has simply purchased an interest in a lease agreement previously entered into by
two other parties.
7.041 ASC Topic 805 amended ASC paragraph 840-10-35-5 to make it clear that an
acquirer’s intent at the acquisition date to negotiate the modification of leases of an
acquiree subsequent to the acquisition date does not change the classification of the
leases:
… At the acquisition date, an acquirer may contemplate renegotiating and
modifying leases of the business or nonprofit activity acquired. Modifications
made after the acquisition date, including those that were planned at the time of
the combination, are postcombination events that shall be accounted for
separately by the acquirer in accordance with the provisions of [ASC] Topic
[840]. …
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
(Pre-ASC Topic 842) Summary of Assets and Liabilities Arising from Lease
Contracts of an Acquiree Recognized by the Acquirer in a Business Combination
7.042 ASC Topic 805 does not provide recognition or measurement exceptions with
respect to lease contracts. Assets and liabilities arising from lease contracts that an
acquiree is party to are evaluated for recognition and measurement in accordance with the
recognition and measurement principles of ASC Topic 805.
7.043 The following table summarizes assets and liabilities that typically arise from lease
contracts of an acquiree assumed in a business combination:
Acquiree as
Lessor
Lessee
Lease Type
Operating
leases
Capital
leases
Sales-type
and direct
financing
leases
Leveraged
leases
X
X
X
X
X
X*
Assets and Liabilities Typically Recognized by
Acquirer
Assets
Leased assets
Favorable lease contract terms
Customer relationships and other
identifiable intangible assets
Leasehold improvements
Favorable lease contract terms
Customer relationships and other
identifiable intangible assets
Capital lease assets
Leasehold improvements
Customer relationships and other
identifiable intangible assets
Lease receivable and
unguaranteed residual value of the
leased asset
Customer relationships and other
identifiable intangible assets
Net rentals receivable
Estimated residual value of the
leased assets
Customer relationships and other
identifiable intangible assets
Liabilities
Unfavorable
lease contract
terms
Unfavorable
lease contract
terms
Capital lease
obligations
Unearned
income
* From the standpoint of the lessee, leveraged leases shall be classified and accounted for
in the same manner as nonleveraged leases. ASC paragraph 840-10-25-33
(Pre-ASC Topic 842) In-Place Leases
7.044 An acquirer may identify value associated with leases in place at the acquisition
date. Value related to in-place leases may reflect, for example, the value associated with
avoiding the cost of originating the acquired in-place leases (costs to execute similar
leases, including marketing costs, leasing commissions, legal, and other related costs), as
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
well as the value associated with the avoidance of holding costs that would be incurred if
an asset intended to be leased was acquired without a lessee. An acquirer should
separately measure an intangible asset (or liability) for in-place leases and for favorable
(unfavorable) leases on a lease-by-lease basis. Generally, we would expect that the
intangible asset for in-place leases, the intangible asset for favorable leases, and the
liability for unfavorable leases to be reported separately in the financial statements.
7.045 We are aware, however, that there is an alternate view that a separate intangible
asset for in-place leases should not be recognized by an acquirer in a business
combination. Under this view, any value ascribed to in-place leases is subsumed in the
measurement of the intangible asset or liability recognized if the terms of the assumed
leases are favorable or unfavorable relative to market terms. However, regardless of
whether a separate intangible asset is separately recognized, or considered in determining
the intangible asset or liability to be recognized for favorable or unfavorable leases, the
value ascribed to in-place leases would be the same. Likewise, there should be no
difference in the subsequent income recognized by the acquiree in postcombination
periods, because the amortization of a separately recognized asset for in-place leases
would be the same as the amortization of the recognized intangible asset or liability
recognized for favorable or unfavorable leases.
7.046 The alternative view (i.e., net presentation) is based in part on an analogy to loan
origination costs related to loans acquired in a business combination, which are not
separately recognized by the acquirer. It is also similar to the FASB’s conclusion
regarding deferred acquisition costs related to insurance contracts, as discussed in FASB
Statement 141(R), par. B190:
The FASB decided that insurance and reinsurance contracts acquired in a business
combination should be accounted for on a fresh-start (new contract) basis.
Accordingly, all assets and liabilities arising from the rights and obligations of
insurance and reinsurance contracts acquired in a business combination are
recognized at the acquisition date, measured at their acquisition-date fair
values…However, those assets acquired and liabilities assumed would not include
the acquiree’s insurance and reinsurance contract accounts such as deferred
acquisition costs and unearned premiums that do not represent future cash flows.
The FASB considers that model the most consistent with the acquisition method
and with the accounting for other types of contracts acquired in a business
combination.
7.047 In determining the fair value of a lease agreement from the lessor’s perspective, all
of the terms of the lease agreement and the assumptions other market participants (e.g.,
other lessors) would be expected to make required consideration. Currently obtainable
rental rates (the rate at which the asset can be leased) for a similar asset may require
adjustment to arrive at the rate used to determine fair value based on the exit price notion
in accordance with ASC Subtopic 820-10 (the rental rate at which a market participant
would replace the acquirer as the lessor). For example, we believe market participants
would consider both the current market rates and the avoided costs normally associated
with in-place leases (which normally would not incrementally affect competitive rates) in
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
determining the rental rates they would require to assume another lessor’s position in a
lease arrangement.
(Pre-ASC Topic 842) Favorable or Unfavorable Lease Contract Terms
ASC Paragraph 805-20-25-12
Regardless of whether the acquiree is the lessee or the lessor, the acquirer shall
determine whether the terms of each of an acquiree’s operating leases are
favorable or unfavorable compared with the market terms of leases of the same or
similar items at the acquisition date. The acquirer shall recognize an intangible
asset if the terms of an operating lease are favorable relative to market terms and a
liability if the terms are unfavorable relative to market terms.
7.048 The terms of lease contracts acquired in a business combination may be favorable
or unfavorable relative to market terms of comparable leases (e.g., with respect to fixed
rental rates, purchase options, renewal provisions, or other terms such as contingent
rental payment adjustments based on revenues or price changes). All of the terms should
be considered in determining whether a lease contract is favorable or unfavorable. In
situations where an acquiree is the lessor in an operating lease contract, we do not believe
the acquirer would ascribe significant value to renewal options that are favorable from
the lessor’s perspective unless circumstances are such that market participants expect that
the lessee will exercise the renewal options. Conversely, if the renewal options are
unfavorable from the perspective of the lessor (acquiree), renewal by the lessee would
normally be assumed by the acquirer. See Section 17 for a discussion of the valuation of
favorable or unfavorable leases.
7.049 Contingent rentals are generally not recognized outside of a business combination
until they become payable. However, the existence of contingent rentals in a lease
contract may affect the measurement of an asset or a liability to be recognized by the
acquirer as a result of terms that are favorable or unfavorable relative to market terms.
Example 7.3: Contingent Rental Provisions in an Operating Lease
ABC Corp. acquires DEF Corp. in a business combination. DEF is a retailer and leases its
retail outlets under operating lease contracts. One of DEF’s operating lease agreements,
with a remaining lease period of 8 years, requires a fixed annual lease payment of
$500,000 plus an additional contingent rental payment equal to 2.5% of annual sales in
excess of $1,000,000. The market rate of an 8-year lease for a similar property is a fixed
annual lease payment of $500,000 plus an additional contingent rental payment equal to
2% of annual sales in excess of $1,000,000. ABC has determined that all other terms of
the lease contracts are consistent with market terms.
In applying the acquisition method, ABC recognizes a liability for an unfavorable lease
contract, due to the unfavorable contingent rental payments relative to market terms for
the remaining 8 years of the lease term (i.e., the contingent rental payments of 2.5% on
annual sales in excess of $1,000,000 is unfavorable to the market rate of 2% on a
comparable lease).
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
(Pre-ASC Topic 842) Presentation of Assets and Liabilities for Favorable or
Unfavorable Operating Lease Contracts Acquired in a Business Combination
7.050 When the acquirer estimates the fair value of acquired operating leases, and
determines that some leases are favorable and others are unfavorable, the acquirer should
present both the respective asset and liability on its balance sheet. Additionally, a
measurement unit should not include both favorable and unfavorable contracts (i.e.,
assets and liabilities should not be netted).
(Pre-ASC Topic 842) Customer Relationships and Other Identifiable Intangible
Assets Associated with Lease Contracts
ASC Paragraph 805-20-25-13
An identifiable intangible asset may be associated with an operating lease, which
may be evidenced by market participants’ willingness to pay a price for the lease
even if it is at market terms. For example, a lease of gates at an airport or of retail
space in a prime shopping area might provide entry into a market or other future
economic benefits that qualify as identifiable intangible assets, such as a customer
relationship. In that situation, the acquirer shall recognize the associated
identifiable intangible asset(s) in accordance with [ASC] paragraph 805-20-25-10.
7.051 An acquiree’s lease contract may be at market terms, but market participants may
be willing to pay a price for the lease because of other identifiable intangible assets
associated with the lease agreement. For example, an acquiree who is the lessor in direct
financing leases may have established customer relationships that meet the recognition
requirements for customer relationship intangible assets in ASC Topic 805. Likewise, an
acquiree who is the lessee of assets may have established customer relationships through
the use of such assets (e.g., through the sublease of such assets) that might also meet the
recognition requirements for customer relationship intangible assets of ASC Topic 805.
Customer relationship intangible assets and other identifiable intangible assets associated
with lease contracts entered into by the acquiree that meet the recognition requirements
of ASC Topic 805 should be separately recognized by the acquirer in its accounting for
the acquisition. See the discussion of Recognition of Intangible Assets Separately from
Goodwill, including the discussion of Customer-Related Intangible Assets, in this Section
and the discussion of valuation of customer relationship intangible assets in Section 17.
Example 7.4: Airport Gate Operating Lease
The amount assigned to an airport gate operating lease contract acquired in a business
combination should be the amount a market participant would be willing to pay for the
contract. The present value of the rent differential may not be an appropriate basis to
estimate the fair value of an acquired gate lease. Generally, airlines lease gates in the U.S.
on a cost recovery basis. The per gate lease amount is established annually through
reference to the annual operating budget of the airport authority. The airport authority
passes on to holders of gate leases a surplus or shortfall of actual-to-budgeted results
through lease rate adjustments in the future. Thus, the lease rate currently obtainable from
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the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
the airport authority (assuming availability of a gate) does not necessarily represent a
market rate that could be used to value the acquired lease. Rather, fair value should be
determined through reference to market transactions for the purchase of gate leases,
adjusted for characteristics of the acquired gate lease.
(Pre-ASC Topic 842) Assets Subject to Operating Leases When the Acquiree Is the
Lessor
ASC Paragraph 805-20-30-5
The acquirer shall measure the acquisition-date fair value of an asset, such as a
building or a patent2 or other intangible asset, that is subject to an operating lease
in which the acquiree is the lessor separately from the lease contract. In other
words, the fair value of the asset shall be the same regardless of whether it is
subject to an operating lease. In accordance with [ASC] paragraph 805-20-25-12,
the acquirer separately recognizes an asset or a liability if the terms of the lease
are favorable or unfavorable relative to market terms.
2 Note that although ASC paragraph 805-20-30-5 refers to a patent or other intangible asset that is subject to
an operating lease, such arrangements would not be accounted for as leases under ASC Topic 840 because
ASC Topic 840 does not apply to licensing agreements for patents or other intangible assets. ASC
paragraph 840-10-15-15
7.052 The fair value of the favorable or unfavorable aspect of an operating lease is
separately recognized and measured as an intangible asset or liability by the acquirer, and
amortized to lease expense on a straight-line basis over the remaining term of the
operating lease subsequent to the acquisition. The fair value of an asset is the same,
regardless of whether it is subject to an operating lease. Separate recognition and
measurement of the favorable or unfavorable aspect of an operating lease and the asset
subject to the operating lease facilitates the appropriate amortization and depreciation of
the respective amounts recognized over their respective useful lives. Statement 141(R),
pars. B144-B147
Example 7.5: Operating Lease of an Acquiree as the Lessor
ABC Corp. acquires DEF Corp. in a business combination. DEF owns an office building,
which is leased to a number of tenants under operating lease contracts for $10 million per
year, with average remaining lease terms of 15 years. The market rate for comparable 15-
year leases is determined to be $8 million per year. ABC determines that market
participants (i.e., lessors of commercial office space) would require a lower rate of return
($7.5 million per year), as a buyer of the leases would not incur marketing costs
(including leasing commissions), costs to negotiate and execute similar lease contracts
(including legal costs), and other related costs. The operating leases provide the lessees
with 2 five-year renewal options, at historical rates plus an inflation factor tied to the
consumer price index. All of the renewal options are favorable to DEF (the lessor), and
thus are unfavorable to the lessees, with no unusual circumstances causing market
participants to assume the renewal options will be exercised. There are no other off-
market terms associated with the operating leases.
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
ABC recognizes the following assets as of the acquisition date:
(1) Building. The building and related assets are recognized and measured at their
acquisition-date fair value, without any consideration being given to the
related lease contracts. The building may or may not be valued as a leased
building, depending on the determination of its highest and best use as
required by ASC Subtopic 820-10.
(2) Favorable Lease Contracts. ABC recognizes an asset for the favorable lease
contracts, due to the difference between the fair value of the future rental
payments ($10 million per year) and the current market rentals required by
market participants ($7.5 million per year). No value is ascribed to the
renewal options, as they are unfavorable to the lessees and there are no
unusual circumstances indicating that the lessees will exercise the renewal
options.
If another identifiable intangible asset is associated with an operating lease, such as a
customer relationship intangible asset, that asset would also be recognized. See
Recognition of Intangible Assets Separately from Goodwill in this Section.
(Pre-ASC Topic 842) Assets Subject to Operating Leases When the Acquiree Is the
Lessee
ASC Paragraph 805-20-25-11
The acquirer shall recognize no assets or liabilities related to an operating lease in
which the acquiree is the lessee except as required by [ASC] paragraphs 805-20-
25-12 through 25-13.
7.053 An acquirer recognizes separately only the assets and liabilities that are specified in
ASC paragraphs 805-20-25-12 and 25-13 related to operating leases in which the
acquiree is the lessee. An acquirer would also recognize leasehold improvements made
by the acquiree at their acquisition-date fair value. See discussion of Operating Leases
under Leasehold and Tenant Improvements in this Section.
(Pre-ASC Topic 842) Prepaid or Accrued Rent Recognized by an Acquiree on
Operating Leases
7.054 Regardless of whether an acquiree is the lessee or lessor, prepaid or accrued rent
previously recorded by an acquiree to recognize rental expense or income on a straight-
line basis in accordance with the provisions of ASC Topic 840 including ASC paragraph
840-20-25-2 should not be recognized under the acquisition method, as such amounts do
not meet the definition of an asset or a liability under Concepts Statement 6. Rather, the
remaining future rental payments required under the terms of an operating lease are
considered in assessing whether an asset or a liability should be recognized by the
acquirer for a favorable or unfavorable contract at the acquisition date.
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
Example 7.6: Prepaid or Accrued Rent Recognized by an Acquiree on
Operating Leases
Q. ABC Corp. purchases DEF Corp. in a business combination. DEF, as lessee, had
recorded $5,000 in accrued rent as of the acquisition date as a result of recognizing lease
expense on existing operating leases on a straight-line basis in accordance with the
provisions of ASC Topic 840. Should ABC recognize the accrued rent as a liability when
accounting for the business acquisition?
A. ABC should not recognize the accrued rent recorded by DEF. The accrued rent is not a
liability under Concepts Statement 6 and, therefore, is not recognized by ABC in
accounting for the business combination. Instead, ABC would recognize an intangible
asset related to operating leases for which the terms for the remainder of the lease periods
(including the required future rental payments) are favorable relative to market terms, or
recognize a liability related to operating leases for which the terms for the remainder of
the lease periods are unfavorable relative to market terms. Any intangible asset or
liability so recognized would be amortized to lease expense during the postcombination
period on a straight-line basis over the remaining term of the operating lease.
(Pre-ASC Topic 842) Capital Lease Contracts of an Acquiree
Capital Lease Assets
7.055 An acquirer should recognize and measure an asset recognized by an acquiree
under a capital lease at its fair value at the acquisition date, consistent with the criteria in
ASC Topic 840 that resulted in capital lease treatment by the acquiree:
•
•
If the acquired lease was capitalized by the acquiree because the lease
transfers title to the lessee (acquiree) or contains a bargain purchase option at
the end of the lease term (i.e., under ASC paragraphs 840-10-25-1(a) and (b)),
the asset underlying the lease would be recognized and measured by the
acquirer at its acquisition-date fair value.
If the acquired leased asset was capitalized by the acquiree because the lease
term is equal to 75% or more of the estimated economic life of the leased
property or because the present value of the minimum lease payments equal or
exceed 90% of the fair value of the leased property (i.e., under ASC
paragraphs 840-10-25-1(c) or (d)), the asset underlying the lease would be
recognized and measured by the acquirer at the fair value of the right to use
the property for the remaining lease term.
7.056 We do not believe that an acquirer would separately recognize an additional asset
or liability related to a favorable or unfavorable contract in either situation, because the
fair value measurements of the capital lease asset and capital lease obligation would
consider all the terms of the lease contract.
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
Capital Lease Obligations
7.057 An acquirer recognizes a capital lease obligation assumed in a business
combination at its acquisition-date fair value. See Section 17 for a discussion of the
determination of the fair value of debt obligations, including capital lease obligations.
(Pre-ASC Topic 842) Leasehold and Tenant Improvements
Operating Leases
7.058 An acquirer recognizes leasehold or other improvements to assets subject to
operating leases made by an acquiree, measured at their acquisition-date fair values,
regardless of whether the acquiree is the lessor or the lessee.
7.059 An acquiree may be the lessor under an operating lease agreement. In such
situations, the acquirer also recognizes leasehold or other tenant improvements made by
lessees to the extent the improvements revert to the acquiree (lessor) at the termination of
the operating lease agreement. These amounts should be measured at the acquisition-date
fair value of the rights to the improvements at the termination of the lease agreement.
Capital Leases
7.060 An acquirer recognizes leasehold or other improvements made by an acquiree to
assets for which the acquiree is the lessee under capital lease contracts, using the above
guidance for capital lease assets.
(Pre-ASC Topic 842) Sales-Type and Direct Financing Leases
Lease Receivables and Unguaranteed Residual Values
7.061 An acquirer recognizes lease receivables and unguaranteed residual values arising
from sales-type and direct financing leases of an acquiree at their acquisition-date fair
values, determined based on the assumptions about discount rates and other factors
market participants would use. We do not believe that an acquirer would separately
recognize an additional asset or liability related to favorable or unfavorable contracts,
because measurement of the fair value of the lease receivables and the unguaranteed
residual values at fair value would consider all of the terms of the lease contracts.
(Pre-ASC Topic 842) Leveraged Leases
7.062 ASC Subtopic 840-30 provides guidance on the accounting by an acquirer for an
acquiree’s investment as a lessor in a leveraged lease.
ASC Paragraph 840-30-25-10
In a business combination or an acquisition by a not-for-profit entity, the
acquiring entity shall retain the classification of the acquired entity’s investment
as a lessor in a leverage lease at the date of the combination. The net investment
of the acquired leveraged lease shall be broken down into its component parts,
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
namely, net rentals receivable, estimates residual value, and unearned income
including discount to adjust other components to present value.
ASC Paragraph 840-30-30-15
In a business combination or an acquisition by a not-for-profit entity, the
acquiring entity shall assign an amount to the acquired net investment in the
leveraged lease in accordance with the general guidance in [ASC] Topic 805,
based on the remaining future cash flows and giving appropriate recognition to
the estimated future tax effects of those cash flows.
ASC Paragraph 805-40-35-32
In a business combination or an acquisition by a not-for-profit entity, the
acquiring entity shall subsequently account for its acquired investment as a lessor
in a leveraged lease in accordance with the guidance in this Subtopic [840-30] as
for any other leveraged lease. Example 5 (see [ASC] paragraph 840-30-55-50)
illustrates an acquiring entity's accounting for its acquired investment as a lessor
in a leveraged lease.
7.063 See ASC paragraphs 840-30-55-50 through 55-56 for a detailed example and
additional guidance on the accounting by an acquirer for an acquiree’s investment in
leveraged leases. A leveraged lease that was entered into before the effective date of
Topic 842 is not subject to the requirements of that Topic (i.e., leveraged lease
accounting continues) unless the lease is modified after the effective date of Topic 842. A
leveraged lease acquired in a business combination on or after the effective date of ASC
Topic 842 retains its classification as a leveraged lease unless the lease is modified as
part of the acquisition. See KPMG Handbook, Leases, Question 7.8.250, Acquisition of a
grandfathered lease.
(Pre-ASC Topic 842) Additional Considerations Related to Lease Contracts
Leases between an Acquirer and an Acquiree Existing at the Acquisition Date
7.064 An acquirer may have a preexisting relationship with the acquiree in the form of a
lease agreement (e.g., where the acquirer is the lessor and the acquiree is the lessee).
Regardless of whether there are noncontrolling interests after the acquisition, the lease
contract would be effectively settled as a result of the acquisition (as the acquirer
consolidates the acquiree following the acquisition). The acquirer recognizes a gain or
loss on the effective settlement of the preexisting relationship in an amount equal to the
lesser of (a) the amount by which the lease is favorable or unfavorable from the
perspective of the acquirer relative to market terms, or (b) the amount of any stated
settlement provisions in the lease available to the counterparty to whom the contract is
unfavorable. See discussion of Preexisting Relationships in Section 11.
Subleases of an Acquiree
7.065 An acquiree may be party to a sublease agreement. For example, a sublease
contract would arise when an acquiree, as the original lessee under an operating lease,
subleases some or all of its right to use the leased asset to a third party. The acquirer
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
should recognize an intangible asset or a liability if the terms of the operating lease
between the acquiree and the original lessor are favorable or unfavorable from the
perspective of the acquiree relative to market terms, and should also separately recognize
an intangible asset or a liability associated with the sublease contract if the terms of the
sublease contract are favorable or unfavorable from the perspective of the acquiree
relative to market terms.
INVOLVEMENT OF A THIRD-PARTY LESSOR IN A BUSINESS COMBINATION
(PRE-TOPIC 842)
7.065a In some business combinations, an unrelated third party may acquire an asset
directly from the acquiree, and in turn lease that asset to the acquirer. If the transaction
between the acquiree and the unrelated third party is contingent on the business
combination between the acquirer and the acquiree, the acquirer should account for the
sale of the asset by the acquiree and the lease from the unrelated third party as a sale-
leaseback transaction.
The acquirer should also account for the sale of the asset by the acquiree and the lease
from the unrelated third party as a post-acquisition sale-leaseback transaction if the
transaction between the acquiree and the unrelated third party is entered into either (1)
after or (2) at or near the same time as the business combination is agreed to by the
acquiree and the acquirer. In these cases, it should be presumed that the sale of the asset
by the acquiree to the unrelated third party contemplated the subsequent lease of that
asset to the acquirer.
RECOGNITION OF INTANGIBLE ASSETS SEPARATELY FROM GOODWILL--
PUBLIC BUSINESS ENTITIES
7.066 ASC Section 805-10-20 defines an intangible asset as an asset (not including a
financial asset) that lacks physical substance (see Section 26 for a discussion of
alternatives available for nonpublic entities). As used in ASC Topic 805, the term
intangible asset excludes goodwill.
7.067 An acquirer recognizes separately from goodwill the identifiable intangible assets
acquired in a business combination. An intangible asset is identifiable if it either:
(1) Is separable, that is, capable of being separated or divided from the entity and
sold, transferred, licensed, rented, or exchanged, either individually or
together with a related contract, identifiable asset, or liability, regardless of
whether the entity intends to do so (referred to as the separability criterion); or
(2) Arises from contractual or other legal rights, regardless of whether those
rights are transferable or separable from the entity or from other rights and
obligations (referred to as the contractual-legal criterion). ASC Section 805-
10-20, ASC paragraph 805-20-25-10
7.068 The separability and contractual-legal criteria were originally developed and
included in Statement 141. The issuance of explicit guidance to assist preparers in
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
identifying such assets, and requiring that such assets be accounted for separately from
goodwill, was deemed appropriate by the FASB in view of the various types of intangible
assets that represent an increasing proportion of the assets of many entities. This guidance
was carried forward to ASC Topic 805.
Contractual-Legal Criterion
ASC Paragraph 805-20-55-2
…An intangible asset that meets the contractual-legal criterion is identifiable even
if the asset is not transferable or separable from the acquiree or from other rights
and obligations. For example:
a. An acquiree leases a manufacturing facility under an operating lease that
has terms that are favorable relative to market terms. The lease terms
explicitly prohibit transfer of the lease (through either sale or sublease). The
amount by which the lease terms are favorable compared with the pricing of
current market transactions for the same or similar items is an intangible asset
that meets the contractual-legal criterion for recognition separately from
goodwill, even though the acquirer cannot sell or otherwise transfer the lease
contract. See also [ASC] paragraphs 805-20-25-12 through 25-13.
b. An acquiree owns and operates a nuclear power plant. The license to
operate that power plant is an intangible asset that meets the contractual-legal
criterion for recognition separately from goodwill, even if the acquirer cannot
sell or transfer it separately from the acquired power plant. An acquirer may
recognize the fair value of the operating license and the fair value of the
power plant as a single asset for financial reporting purposes if the useful lives
of those assets are similar.
c. An acquiree owns a technology patent. It has licensed that patent to others
for their exclusive use outside the domestic market, receiving a specified
percentage of future foreign revenue in exchange. Both the technology patent
and the related license agreement meet the contractual-legal criterion for
recognition separately from goodwill even if selling or exchanging the patent
and the related license agreement separately from one another would not be
practical.
7.069 Many intangible assets arise from rights conveyed legally by contract, statute, or
similar means. For example, franchises are granted to automobile dealers, fast food
outlets, and professional sports teams; trademarks and service marks may be registered
with the government; contracts are often negotiated with customers or suppliers; and
patents often protect technological and scientific innovations. The FASB concluded that
an intangible asset arising from contractual or other legal rights is an important
characteristic that distinguishes many intangible assets from goodwill, and an acquired
intangible asset with that characteristic should be recognized separately from goodwill.
Statement 141(R), par. B163
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
7.070 All intangible assets acquired in a business combination that meet the contractual-
legal criterion are recognized at the acquisition date. Some intangible assets that meet the
contractual-legal criterion may also be separable; however, separability is not a required
condition for an intangible asset that meets the contractual-legal requirement to be
recognized.
Separability Criterion
ASC Paragraph 805-20-55-3
The separability criterion means that an acquired intangible asset is capable of
being separated or divided from the acquiree and sold, transferred, licensed,
rented, or exchanged, either individually or together with a related contract,
identifiable asset, or liability. An intangible asset that the acquirer would be able
to sell, license, or otherwise exchange for something else of value meets the
separability criterion even if the acquirer does not intend to sell, license, or
otherwise exchange it.
ASC Paragraph 805-20-55-4
An acquired intangible asset meets the separability criterion if there is evidence of
exchange transactions for that type of asset or an asset of a similar type, even if
those transactions are infrequent and regardless of whether the acquirer is
involved in them. For example, customer and subscriber lists are frequently
licensed and thus meet the separability criterion. Even if an acquiree believes its
customer lists have characteristics different from other customer lists, the fact that
customer lists are frequently licensed generally means that the acquired customer
list meets the separability criterion. However, a customer list acquired in a
business combination would not meet the separability criterion if the terms of
confidentiality or other agreements prohibit an entity from selling, leasing, or
otherwise exchanging information about its customers.
7.071 An intangible asset meets the separability criterion if it is capable of being sold,
transferred, licensed, rented, or exchanged, either individually or together with a related
contract, identifiable asset, or liability. Thus, only the capability of an asset to be
separated from the entity and exchanged for something else of value is required, not
management’s intent to do so. If the sale, transfer, license, rent or exchange of an
intangible asset is restricted by law or agreement, then the separability criterion has not
been met.
7.072 If an intangible asset is not capable of being separated from the entity by itself, but
can be combined with a related contract, identifiable asset, or liability and separated, the
separability criterion is met. This provision is included in ASC Topic 805 to address the
FASB’s observation that some intangible assets are so closely related to another asset or
liability that they are usually sold as a package; and if those intangible assets were
subsumed into goodwill, gains might inappropriately be recognized if the intangible asset
was later sold along with the related asset or obligation. However, related contract,
identifiable asset, or liability requires a close relationship to the identified intangible
asset (e.g., deposit liabilities and the related depositor relationship intangible asset), and
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
does not extend to intangible assets that can only be separated as part of an asset group
(ASC Section 360-10-20 defines asset group as “the lowest level for which identifiable
cash flows are largely independent of the cash flows of other groups of assets and
liabilities”). Statement 141(R), pars. B166-B167 and B169
7.073 The following examples from ASC paragraph 805-20-55-5 illustrate the
identification of acquired intangible assets that are separable from the acquiree only in
combination with a related contract, asset, or liability.
Example 7.7: Depositor Relationships
Market participants exchange deposit liabilities and related depositor relationship
intangible assets in observable exchange transactions. Therefore, the acquirer should
recognize a depositor relationship intangible asset separately from goodwill.
Example 7.8: Registered Trademarks
An acquiree owns a registered trademark and documented but unpatented technical
expertise used to manufacture the trademarked product. To transfer ownership of a
trademark, the owner is also required to transfer everything else necessary for the new
owner to produce a product or service indistinguishable from that produced by the former
owner. Because the unpatented technical expertise can be separated from the acquiree or
combined entity and sold if the related trademark is sold, it meets the separability
criterion.
Items That Are Not Identifiable
7.074 ASC Section 805-10-20 defines goodwill as “an asset representing the future
economic benefits arising from other assets acquired in a business combination . . . that
are not individually identified and separately recognized.” An intangible asset that does
not meet either the separability criterion or the legal-contractual criterion at the
acquisition date is subsumed into goodwill. Likewise, any value attributable to items that
do not qualify as assets at the acquisition date are subsumed into goodwill. See Section
22 for additional guidance on goodwill and other intangible assets and KPMG Handbook,
Impairment of Nonfinancial Assets.
Assembled Workforce
7.075 An assembled workforce is an example of an item that is not an identifiable
intangible asset, and thus is not recognized separately but is subsumed into goodwill. An
assembled workforce is “an existing collection of employees that permits the acquirer to
continue to operate an acquired business from the acquisition date.” ASC paragraph 805-
20-55-6
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
7.076 The FASB noted that because an assembled workforce is a collection of
employees, it does not arise from contractual or legal rights (although individual
employees might have employment contracts with the employer, the collection of
employees, as a whole, does not have such a contract). The FASB also noted that an
assembled workforce is not separable, either as individual employees or together with a
related contract, identifiable asset, or liability. An assembled workforce cannot be sold,
transferred, licensed, rented, or otherwise exchanged without causing disruption to the
acquirer’s business. In contrast, an entity could continue to operate after transferring an
identifiable asset. Statement 141(R), par. B178
7.077 We do not believe that a collective bargaining agreement would support
recognition of an intangible asset for the workforce covered by the agreement. Such
agreements normally do not obligate the covered employees to remain with the employer
for a specified period. However, we believe the underlying contract, similar to other
contractual agreements, could meet the criteria for identification as a separate intangible
asset (favorable contract terms) or a liability (unfavorable contract terms), although we
believe these situations would arise only in limited circumstances, such as those in which
the existence of a collective bargaining agreement gives an acquiree a distinct advantage
in its competitive marketplace.
7.078 We do not believe that a group of individual employment contracts entered into by
an acquiree with a broad group of employees should be viewed, collectively, as an
assembled workforce. However, the facts and circumstances in each situation should be
evaluated. For example, noncompete provisions included in such contracts should be
separately evaluated and recognized as identifiable intangible assets. See discussions of
Noncompete Agreements and Employment Contracts in this Section.
Items That Do Not Qualify as Assets at the Acquisition Date
7.079 The acquirer also subsumes into goodwill any value attributed to items that do not
qualify as assets (i.e., do not meet the definition of assets in Concepts Statement 6) at the
acquisition date. For example, the acquirer might attribute value to potential contracts the
acquiree is negotiating with prospective new customers at the acquisition date. Because
the potential contracts are not themselves assets at the acquisition date, the acquirer does
not recognize them separately from goodwill. The acquirer should not reclassify the value
of those contracts from goodwill for events that occur after the acquisition date.
However, the acquirer should assess the facts and circumstances surrounding events
occurring shortly after the acquisition to determine whether a separately recognizable
intangible asset existed at the acquisition date. (ASC paragraph 805-20-55-7) See Section
10 for a discussion of the Measurement Period.
7.080 If potential contracts the acquiree was negotiating with new customers at the date
of the acquisition were a significant consideration in negotiating and completing the
acquisition, and the potential contracts are not obtained following the acquisition,
consideration should be given as to whether the event is a change in events or
circumstance that would more likely than not reduce the fair value of a reporting unit
below its carrying amount and, thus, trigger an impairment test. See Section 22 and
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
KPMG Handbook, Impairment of nonfinancial assets, for additional discussion on
frequency of impairment testing.
Illustrative List of Intangible Assets That Are Identifiable
7.081 The following table lists intangible assets that meet the identifiable criteria (i.e.,
that either arise from contractual-legal rights or are separable) for recognition as
intangible assets apart from goodwill. This list, compiled from ASC paragraphs 805-20-
55-11 through 55-45 with the addition of in-process research and development, is not
intended to be all-inclusive. Additional discussion and examples of intangible assets that
would be recognized separately from goodwill are presented following the table. See
Section 26 for more information.
Contractual / Legal*
Separable**
Marketing-Related
Trademarks and trade names
Service marks, collective marks, and
certification marks
Trade dress (unique color, shape, or
package design)
Newspaper mastheads
Internet domain names
Noncompete agreements
Customer-Related
Order or production backlog
Customer contracts and related customer
Customer lists
Noncontractual
relationships
customer
relationships
Artistic-Related
Plays, operas, ballets
Books, magazines, newspapers, and other
literary works
Musical works such as compositions,
song lyrics, and advertising jingles
Pictures and photographs
Video and audiovisual material, including
motion pictures or films, music videos,
and television programs
Contract-Based
Licensing, royalty, and standstill
agreements
Advertising, construction, management,
service, or supply contracts
Lease agreements (whether the acquiree
is the lessee or the lessor)
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
Construction permits
Franchise agreements
Operating and broadcast rights
Use rights (e.g., drilling, water, air,
mineral, timber cutting, and route
authorities)
Servicing contracts (e.g., mortgage
servicing)
Employment contracts
Technology-Based
Patented technology
Computer software and mask works
Unpatented technology
Databases (e.g., title
Trade secrets (e.g., secret formulas,
processes, and recipes)
In-process research
and development
plants)
* Intangible assets arising from contractual or other legal rights without regard to
separability. Assets meeting this criterion might also be separable, but separability is not a
necessary condition for an asset to meet the contractual-legal criterion.
** Intangible assets arising because of an ability to separate. Customer lists would not
meet the separability criterion to be recognized apart from goodwill if the terms of
confidentiality or other agreements prohibit an entity from selling, leasing, or otherwise
exchanging the asset. ASC paragraphs 805-20-55-3 through 55-4
Marketing-Related Intangible Assets
7.082 Marketing-related intangible assets are often protected through registration with
governmental agencies or by other means and, in such instances, meet the contractual-
legal criterion. If such assets do not meet the contractual-legal criterion, they are
recognized separately from goodwill only if the separability criterion is met. ASC
paragraphs 805-20-55-16 through 55-19 include a discussion of certain marketing-related
intangible assets:
Trademarks, Trade Names, Service Marks, Collective Marks, and
Certification Marks
ASC Paragraph 805-20-55-16
Trademarks are words, names, symbols, or other devices used in trade to indicate
the source of a product and to distinguish it from the products of others. A service
mark identifies and distinguishes the source of a service rather than a product.
Collective marks identify the goods or services of members of a group.
Certification marks certify the geographical origin or other characteristics of a
good or service.
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ASC Paragraph 805-20-55-17
Trademarks, trade names, service marks, collective marks, and certification marks
may be protected legally through registration with governmental agencies,
continuous use in commerce, or by other means. If it is protected legally through
registration or other means, a trademark or other mark acquired in a business
combination is an intangible asset that meets the contractual-legal criterion.
Otherwise, a trademark or other mark acquired in a business combination can be
recognized separately from goodwill if the separability criterion is met, which
normally it would be.
ASC Paragraph 805-20-55-18
The terms brand and brand name, often used as synonyms for trademarks and
other marks, are general marketing terms that typically refer to a group of
complementary assets such as a trademark (or service mark) and its related trade
name, formulas, recipes, and technological expertise. This Statement does not
preclude an entity from recognizing, as a single asset separately from goodwill, a
group of complementary intangible assets commonly referred to as a brand if the
assets that make up that group have similar useful lives.
Internet Domain Names
ASC Paragraph 805-20-55-19
An Internet domain name is a unique alphanumeric name that is used to identify a
particular numeric Internet address. Registration of a domain name creates an
association between that name and a designated computer on the Internet for the
period of the registration. Those registrations are renewable. A registered domain
name acquired in a business combination meets the contractual-legal criterion.
Noncompete Agreements
7.083 Noncompete agreements are agreements that place restrictions on a person’s or a
business’ ability to compete with another entity and, as such, meet the contractual-legal
criterion for recognition as intangible assets. The restrictions generally relate to specified
markets and/or specified products or activities for some period of time. These agreements
may be entered into on a stand-alone basis, or may be embedded in another agreement,
such as an acquisition agreement or an employment contract.
7.084 The valuation of noncompete agreements is often difficult and requires
consideration of many factors, including uncertainties about enforceability, the effect of
competition absent the noncompete agreement, etc. See Section 17 for a discussion of the
fair value measurement of noncompete agreements. Section 26 discusses the private
company and not-for-profit accounting alternative related to recognition of noncompete
agreements.
Customer-Related Intangible Assets
7.085 Customer-related intangible assets typically include intangible assets that meet the
contractual-legal criterion and intangible assets that meet the separability criterion. See
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Section 26 for a discussion of the private company and not-for-profit accounting
alternative related to recognition of certain customer-related intangible assets.
Customer Lists
7.086 A customer list consists of information about customers, such as names and contact
information. A customer list also may be a database that includes other information about
the customers, such as order histories and demographic information. Customer lists
generally do not arise from contractual or other legal rights, but are frequently leased or
exchanged. Therefore, a customer list acquired in a business combination normally meets
the separability criterion. (ASC paragraph 805-20-55-21) If terms of confidentiality or
other agreements prohibit an entity from selling, leasing, or otherwise exchanging
information about its customers, the acquired customer list would not meet the
separability criterion. ASC paragraph 805-20-55-4
7.087 It is important to distinguish between a customer list and a customer base. A
customer list includes specific information about the customer, such as name, contact
information, order history, and demographic information. A customer base does not meet
the criteria for recognition apart from goodwill because a customer base represents a
group of customers that are neither known nor identifiable to the entity (e.g., the
customers that visit a particular fast-food restaurant).
Order or Production Backlog
7.088 Order or production backlog arises from contracts such as purchase or sales orders.
An order or production backlog acquired in a business combination meets the
contractual-legal criterion even if the purchase or sales orders are cancelable. ASC
paragraph 805-20-55-22
Customer Contracts and Related Customer Relationships
7.089 If an entity establishes relationships with its customers through contracts, those
customer relationships arise from contractual rights. Therefore, customer contracts and
the related customer relationships acquired in a business combination meet the
contractual-legal criterion, even if confidentiality or other contractual terms prohibit the
sale or transfer of a contract separately from the acquiree. ASC paragraph 805-20-55-23
7.090 A customer contract and the related customer relationship may represent two
distinct intangible assets. Both the useful lives and the pattern in which the economic
benefits of the two assets are consumed may differ. ASC paragraph 805-20-55-24
7.091 A customer relationship exists between an entity and its customer if (a) the entity
has information about the customer and has regular contact with the customer, and (b) the
customer has the ability to make direct contact with the entity. Customer relationships
meet the contractual-legal criterion if an entity has a practice of establishing contracts
with its customers, regardless of whether a contract exists at the acquisition date.
Customer relationships also may arise through means other than contracts, such as
through regular contact by sales or service representatives. As noted in ASC paragraph
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805-20-55-22, an order or a production backlog arises from contracts such as purchase or
sales orders and therefore is a contractual right. Consequently, if an entity has
relationships with its customers through these types of contracts, the customer
relationships also arise from contractual rights and therefore meet the contractual-legal
criterion. ASC paragraph 805-20-55-25
Example 7.9: Order Backlog
Acquirer Company (AC) acquires Target Company (TC) in a business combination on
December 31, 20X5. TC does business with its customers solely through purchase and
sales orders. At December 31, 20X5, TC has a backlog of customer purchase orders from
60 percent of its customers, all of whom are recurring customers. The other 40 percent of
TC’s customers also are recurring customers. However, as of December 31, 20X5, TC
has no open purchase orders or other contracts with those customers. Regardless of
whether they are cancelable or not, the purchase orders from 60 percent of TC’s
customers meet the contractual-legal criterion. Additionally, because TC has established
its relationship with 60 percent of its customers through contracts, not only the purchase
orders but also TC’s customer relationships meet the contractual-legal criterion. Because
TC has a practice of establishing contracts with the remaining 40 percent of its
customers, its relationship with those customers also arises through contractual rights and
therefore meets the contractual-legal criterion even though TC does not have contracts
with those customers at December 31, 20X5. ASC paragraph 805-20-55-56
Example 7.10: Customer Relationships (No Existing Contracts)
An entity may acquire an acquiree involved in a seasonal business during its off-season
when typical customer contracts do not exist. If the acquiree has a practice of establishing
customer relationships through contracts at a time other than at the acquisition date, the
acquiree’s customer relationships are considered to arise from contractual rights.
7.092 Additional examples of customer contracts and related customer relationships
intangible assets are presented below.
Example 7.11: Customer Relationships—Contractual-Legal Criterion
AC acquires TC in a business combination on December 31, 20X5. TC has a five-year
agreement to supply goods to Customer. Both TC and AC believe that Customer will
renew the agreement at the end of the current contract. The agreement is not separable.
The agreement, whether cancelable or not, meets the contractual-legal criterion.
Additionally, because TC establishes its relationship with Customer through a contract,
not only the agreement itself but also TC’s customer relationship with Customer meet the
contractual-legal criterion. ASC paragraph 805-20-55-54
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Example 7.12: Customer Relationships—More Than One Relationship with
a Single Customer
AC acquires TC in a business combination on December 31, 20X5. TC manufactures
goods in two distinct lines of business: sporting goods and electronics. Customer
purchases both sporting goods and electronics from TC. TC has a contract with Customer
to be its exclusive provider of sporting goods but has no contract for the supply of
electronics to Customer. Both TC and AC believe that only one overall customer
relationship exists between TC and Customer.
The contract to be Customer’s exclusive supplier of sporting goods, whether cancelable
or not, meets the contractual-legal criterion. Additionally, because TC establishes its
relationship with Customer through a contract, the customer relationship with Customer
meets the contractual-legal criterion. Because TC has only one customer relationship with
Customer, the fair value of that relationship incorporates assumptions about TC’s
relationship with Customer related to both sporting goods and electronics. However, if
AC determines that the customer relationships with Customer for sporting goods and for
electronics are separate from each other, AC would assess whether the customer
relationship for electronics meets the separability criterion for identification as an
intangible asset. ASC paragraph 805-20-55-55
Example 7.13: Customer Relationships—Contractual-Legal Criterion
AC acquires TC, an insurer, in a business combination on December 31, 20X5. TC has a
portfolio of one-year motor insurance contracts that are cancelable by policyholders.
Because TC establishes its relationships with policyholders through insurance contracts,
the customer relationship with policyholders meets the contractual-legal criterion. ASC
Subtopic 350-30 applies to the customer relationship intangible asset. ASC paragraph
805-20-55-57
Example 7.14: Customer Relationships Not Recognized (Contractual-Legal
Criterion Not Met) and Customer List Not Recognized Due to Confidentiality
Restrictions)
ABC Corp. acquires DEF Corp., a medical testing facility, in a business combination on
December 31, 20X5. DEF provides testing services to patients, such as blood screening,
based on referrals from their physicians (i.e., DEF does not have a contractual
relationship with its customers). DEF maintains a database with each patient’s
information, such as name, address, telephone number, doctor’s name, insurer’s name,
and policy number. DEF’s patients are Medicare patients, and patient information is
protected by privacy rules (e.g., HIPPA).
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ABC should not recognize a separate intangible asset for DEF’s customer relationships
because ABC determines that those relationships do not meet the contractual-legal
criterion. Additionally, the customer list does not meet the separability criterion because
privacy rules and regulations over patient information prevent selling, transferring,
licensing, or exchanging patient information separately from the acquired entity.
Example 7.15: Customer Relationships—Overlapping Customer
Relationships – Scenario 1
Q. ABC Corp. acquires DEF Corp. in a business combination. ABC and DEF operate in
the same industry and both sell their products to Customer A. Assuming that the
relationship meets the separability or legal-contractual criterion, should ABC recognize
an intangible asset for DEF’s relationship with Customer, in view of the fact that ABC
already has a relationship with Customer A?
A. ABC should recognize a customer relationship intangible asset for DEF’s relationship
with Customer. However, the fair value of the asset depends on the specific facts and
circumstances. For example, if other market participants are expected to have a customer
relationship with Customer A and would not ascribe any value to DEF’s relationship with
Customer A as a result of the acquisition of DEF, the intangible asset may have very little
value. However, if other market participants are not expected to have a customer
relationship with Customer A, or would be expected to place additional value on the
relationship as a result of the acquisition of DEF, ABC should recognize the acquired
customer relationship as a separately identifiable intangible asset, measured at fair value,
based on the assumptions market participants would use.
Example 7.16: Customer Relationships—Overlapping Customer
Relationships – Scenario 2
Q. Assume the same fact pattern as Example 7.15, except ABC Corp. intends to
discontinue selling the products that are the basis of DEF’s relationship with Customer A.
Should ABC recognize the relationship with Customer A as a separately identifiable
intangible asset?
A. It depends. If market participants would also discontinue selling the products that are
the basis of DEF’s relationship with Customer A and would place no value on the
relationship, then ABC would not recognize an intangible asset for DEF’s relationship
with Customer A. However, if market participants would continue selling the products
that are the basis of DEF’s relationship with Customer A, ABC should recognize the
acquired customer relationship as a separately identifiable intangible asset measured at
fair value, based on the assumptions market participants would use. See discussion of
Assets That the Acquirer Intends Not to Use or to Use in a Way Other Than Their
Highest and Best Use in this Section.
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Example 7.17: Acquiree’s Preexisting Customer Relationship With Acquirer
Is Not Recognized as a Customer Relationship Intangible Asset by the
Acquirer
ABC Corp. acquires DEF Corp., one of its suppliers, in a business combination. One of
the strategic reasons for acquiring DEF is to gain access to DEF’s customers (ABC is one
DEF’s customers). It would not be appropriate for ABC to include DEF’s relationship
with ABC in the measurement of the customer relationship intangible asset arising from
the acquisition of DEF, because the asset cannot be disposed of and there are no future
economic benefits from the customer relationship that the consolidated entity could
realize with parties outside of the group. In addition, from the perspective of the
consolidated group, the definition of an asset is not met.
Q&A 7.0: Customer Relationships - Healthcare Patient Relationships
Q. Can an acquirer recognize intangible assets in an acquisition of a healthcare entity,
such as a physician practice, related to patient relationships when there are regulatory
restrictions?
A. Generally, no. An acquirer will not recognize an intangible asset related to customer
relationships (i.e., patients) when acquiring a healthcare entity.
When assessing the separability and contractual-legal criteria in this scenario, a
healthcare entity should consider the regulatory environment in which it operates. Certain
laws and regulations (e.g., The Federal Anti-Kickback Statutes, the Stark Law and the
privacy laws) were established to protect the patient and prevent fraud and abuse among
healthcare organizations, providers, payors, manufacturers, and other entities receiving
federal reimbursement through Medicare and Medicaid programs.
Therefore, a patient relationship intangible asset that is not capable of being sold,
transferred, licensed, rented, or exchanged will not meet the separability criterion because
doing so could indicate a potential violation of certain laws and regulations.
The legal environment in which healthcare entities operate prohibits actual or implied
ongoing contracts with patients and any control by the healthcare entity over the future
economic benefits of patient care. Therefore, generally there are no contractual or legal
rights that arise in a combination between an acquirer and a healthcare entity (e.g.,
physician practice) for patient relationships (e.g., patient lists). Accordingly, the
contractual legal criterion will not be met.
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Noncontractual Customer Relationships
7.093 A customer relationship acquired in a business combination that does not arise
from a contract may nevertheless be identifiable because the relationship is separable.
Exchange transactions for the same or a similar asset that indicate that other entities have
sold or otherwise transferred a particular type of noncontractual customer relationship
would provide evidence that the noncontractual customer relationship is separable. For
example, relationships with depositors are frequently exchanged with the related deposits
and therefore meet the criteria for recognition as an intangible asset separately from
goodwill. ASC paragraph 805-20-55-27
Artistic-Related Intangible Assets
7.094 Artistic-related assets acquired in a business combination are identifiable if they
arise from contractual or legal rights such as those provided by copyright. The holder can
transfer a copyright, either in whole through an assignment or in part through a licensing
agreement. An acquirer is not precluded from recognizing a copyright intangible asset
and any related assignments or license agreements as a single asset, provided they have
similar useful lives. ASC paragraph 805-20-55-30
Contract-Based Intangible Assets
7.095 Many contract-based intangible assets arise from noncancelable executory
contracts. Accounting for noncancelable executory contracts acquired in a business
combination is similar to accounting for operating leases acquired in a business
combination. An asset or liability should be recognized as part of the accounting for the
acquisition to the extent the terms of the noncancelable contract are favorable or
unfavorable compared with the market terms of the same or similar items at the
acquisition date.
7.096 Contract-based intangible assets represent the value of rights that arise from
contractual arrangements. Customer contracts are one type of contract-based intangible
asset. If the terms of a contract are favorable or unfavorable relative to market terms, the
acquirer recognizes an intangible asset or a liability in its accounting for the acquisition.
(ASC paragraph 805-20-55-31) If a separate favorable or unfavorable intangible asset or
liability is recognized for a customer contract, we believe the amortization of that asset or
liability should be classified as revenue in the income statement. Additionally, an at-
market executory contract such as a revenue, lease or other type of contract may also
have inherent fair value that gives rise to other identifiable intangible assets that should
be recognized in the acquisition accounting. For example, a lease of gates at an airport or
of retail space in a prime shopping area might provide entry into a market or other future
economic benefits that qualify as identifiable intangible assets, such as a customer
relationship.
Licensing Agreements
7.097 Licensing agreements involve contractual arrangements under which the owner
(licensor) of an asset (e.g., intellectual property, trademarks, or copyrighted works) grants
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permission to a licensee to use the asset, usually for a fee. Licensing agreements typically
include terms relating to the fees to be paid by the licensee to the licensor, period of use,
stipulations on use (e.g., geographic area), and renewal.
(Pre-ASC Topic 606) Long-Term Construction-Type Contracts
7.098 If an acquiree in a business combination is involved in long-term construction-type
contracts (LTCCs), the acquirer should recognize an asset or a liability with respect to
each contract of the acquiree that is in process as of the acquisition date. The amount
recognized is equal to the acquisition-date fair value of each LTCC. Fair value is the
amount market participants would require to be paid or would pay to assume the rights
and obligations of the acquiree under the contract, and is not affected by the method used
by the acquiree to account for the contract (i.e., the percentage-of-completion method or
the completed-contract method). An acquired LTCC may consist of a customer
relationship, contract backlog, an off-market component, and an asset (liability) to the
extent that costs exceed billings (or vice versa). If some contracts result in the recognition
of an asset, and others result in the recognition of a liability, the amounts should be
separately presented in the postcombination financial statements of the combined entity
(i.e., assets and liabilities should not be offset). In addition, to the extent that a separately
identifiable customer relationship intangible asset exists, we believe that its fair value
should be recognized separately from the LTCC. See Section 17 for guidance on the
measurement of fair value of long-term construction-type contracts.
7.099 The method of accounting used by the acquirer to account for long-term
construction-type contracts subsequent to the acquisition is not an accounting policy
election, but is based on the facts and circumstances related to each contract. The acquirer
should evaluate each acquired contract at the acquisition date to determine the
appropriate method of accounting under the provisions of ASC Subtopic 605-35, Revenue
Recognition—Construction-Type and Production-Type Contracts. The method of
accounting used by an acquiree to account for a long-term construction-type contract
before its acquisition in a business combination is not necessarily determinative of the
accounting method to be used by the acquirer after the acquisition.
Purchase and Supply Contracts
7.100 Purchase and supply contracts for the acquisition of supplies or items used in the
manufacturing and production process, and contracts for the sale of products, are
executory contracts. To the extent the terms of a purchase or supply contract of an
acquiree are favorable or unfavorable compared with the market terms for the same or
similar items at the acquisition date, the acquirer should recognize an intangible asset or a
liability.
Example 7.18: Supply Contracts
Q. An acquiree has several long-term supply contracts on which it is generating operating
losses. The losses arise because the business is operating at less than full capacity, and
because the selling prices in the contracts are below the market terms of the same or
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similar items at the acquisition date. All other terms of the contracts are consistent with
current market terms for the same or similar contracts.
Should the acquirer recognize a liability at the acquisition date for the supply contracts as
part of the acquisition accounting?
A. Yes. The acquirer should recognize a liability for the unfavorable contracts. The
amount recognized should be the fair value of the amount by which the terms of the
supply contract are unfavorable relative to market terms. In this case, the determination
of the liability to be recognized would be based on the fair value of the differential
between the selling prices in the contracts and the current market terms for the same or
similar items at the acquisition date. However, the acquirer should not recognize a
liability for the inefficiencies of operating the plant at less than full capacity.
See Sections 16 through 21 for guidance on the measurement of intangible assets or
liabilities arising from unfavorable contracts assumed in an acquisition.
(Pre-ASC Topic 842) Lease Contracts
7.101 Various assets and liabilities arise from lease contracts of an acquiree assumed by
an acquirer in a business combination.
Franchise Agreements
7.102 Franchise agreements are contractual arrangements through which a party (the
franchisor) grants rights to another party (the franchisee) to operate a franchised business
for a specified period. The purpose of the agreement is the distribution of a product or
service, or an entire business concept, within a particular market area. See ASC Topic
952, Franchisors. In addition to intangible assets or liabilities an acquirer recognizes as a
result of terms of a franchise agreement entered into by an acquiree that are favorable or
unfavorable relative to market terms, there may be additional intangible assets that the
acquirer should recognize (e.g., customer list and/or customer contracts and related
customer relationships intangible assets).
Use Rights
7.103 Use rights such as drilling, water, air, timber cutting, and route authorities are
contract-based intangible assets that are accounted for separately from goodwill.
However, certain use rights may have characteristics of tangible assets, rather than
intangible assets. For example, certain mineral rights, defined as the right to explore,
extract, and retain at least a portion of the benefits from mineral deposits, are tangible
assets. Use rights should be accounted for based on their nature. ASC paragraph 805-20-
55-37
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Servicing Contracts
7.104 Contracts to service financial assets are one type of contract-based intangible asset.
Although servicing is inherent in all financial assets, it becomes a distinct asset (or
liability) by one of the following:
(a) If the transfer of the servicer’s financial assets meet the requirements for
sale accounting; or
(b) Through the separate acquisition or assumption of a servicing obligation
that does not relate to financial assets of the combined entity.
7.105 ASC Subtopic 860-50, Transfers and Servicing - Servicing Assets and Liabilities,
provides guidance on accounting for servicing contracts. ASC paragraphs 805-20-55-33
through 55-34
7.106 If mortgage loans, credit card receivables, or other financial assets are acquired in a
business combination with the servicing obligation, the inherent servicing rights are not a
separate intangible asset because the fair value of those servicing rights is included in the
measurement of the fair value of the acquired financial asset. ASC paragraph 805-20-55-
35
Employment Contracts
7.107 Employment contracts that are favorable to an acquiree (employer) because the
pricing of the contracts is favorable (from the acquiree’s perspective) relative to market
terms (using a market participant’s perspective) are recognized as intangible assets by the
acquirer. (ASC paragraph 805-20-55-36) Employment contracts that are unfavorable to
an acquiree (employer) are recognized as liabilities by the acquirer.
7.108 Identifying employment contracts of an acquiree that are favorable or unfavorable,
and that would qualify for recognition as an intangible asset or a liability by an acquirer,
will often prove difficult. For example, such identification will first require a
determination as to the enforceability of the contract. The measurement of such contracts,
if determined to be enforceable, may also prove difficult. For example, if an employment
contract is identified as favorable and enforceable, little or no value may be assigned to
the contract by the acquirer unless a market participant would be expected to enforce the
contract. Similarly, if a contract is identified as unfavorable and enforceable, the
measurement of the fair value of the unfavorable contract would take into consideration,
among other things, the likelihood that the employee would seek enforcement of the
contract, the likelihood that the contract could be settled, and other relevant
considerations.
7.109 An example of a situation where favorable or unfavorable employment contracts
might be recognized would be the acquisition of a professional sports team where player
contracts prohibit or place limitations on players’ ability to move to another team, and
prohibit or place limitations of the sports team’s ability to trade its player rights to
another team. In such instances, there may be sufficient evidence to support the
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enforceability of both favorable and unfavorable player contracts and, in such event, an
acquirer would recognize an intangible asset for favorable contracts and a liability for
unfavorable contracts, based on the pricing of the contracts relative to market terms.
7.110 Employment contracts entered into by an acquiree may include noncompete
provisions. Noncompete agreements should be separately recognized and measured by
the acquirer. See Section 17 for a discussion of the measurement of favorable or
unfavorable employment contracts and noncompete agreements.
Technology-Based Intangible Assets
Patented and Unpatented Technology
7.111 Technology-related assets generally comprise a set of technical processes,
intellectual property, and the institutional understanding within an organization with
respect to various processes and products. Those assets generally can be classified as
patented and unpatented technology. By definition, a patent is a right granted from the
government or other public authorities that confers on the creator the sole right to make,
use, or sell an invention for a set period of time. As some companies do not aggressively
pursue patents, unpatented or proprietary technology also should be examined. Patented
technology with legal protection meets the contractual-legal criterion for recognition as
an intangible asset. Unpatented technology may meet the separability criterion to be
recognized apart from goodwill unless there are restrictive terms that prohibit an entity
from selling, leasing, or otherwise exchanging the technology.
Computer Software and Mask Works
7.112 Computer software and program formats acquired in a business combination that
are protected legally, such as by patent or copyright, meet the contractual-legal criterion
for identification as intangible assets. Mask works are software permanently stored on a
read-only memory chip as a series of stencils or integrated circuitry. Mask works with
legal protection that are acquired in a business combination meet the contractual-legal
criterion for recognition as intangible assets separately from goodwill. ASC paragraphs
805-20-55-40 through 55-41
Trade Secrets (e.g., Secret Formulas, Processes, and Recipes)
7.113 A trade secret is “information, including a formula, pattern, recipe, compilation,
program, device, method, technique, or process that (1) derives independent economic
value, actual or potential, from not being generally known and (2) is the subject of efforts
that are reasonable under the circumstances to maintain its secrecy.”3 If the future
economic benefits from a trade secret acquired in a business combination are legally
protected, that asset meets the contractual-legal criterion. Otherwise, trade secrets
acquired in a business combination are identifiable only if the separability criterion is
met, which is likely to be the case. However, if the trade secret is not legally protected,
the fair value of the trade secret could be lower. ASC paragraph 805-20-55-45
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3 ASC paragraph 805-20-55-44: Melvin Simensky and Lanning Bryer, The New Role of Intellectual
Property in Commercial Transactions (New York: John Wiley & Sons, 1998), 293
Databases, Including Title Plants
7.114 Databases are collections of information, often stored in electronic form (such as
on computer disks or files). A database that includes original works of authorship may be
entitled to copyright protection. A database acquired in a business combination that is
protected by copyright meets the contractual-legal criterion. However, a database
typically includes information created as a consequence of an entity’s normal operations,
such as customer lists, or specialized information, such as scientific data or credit
information. Databases that are not protected by copyright can be, and often are,
exchanged, licensed, or leased to others in their entirety or in part. Therefore, even if the
future economic benefits from a database do not arise from legal rights, a database
acquired in a business combination meets the separability criterion. ASC paragraph 805-
20-55-42
7.115 Title plants constitute a historical record of all matters affecting title to parcels of
land in a particular geographical area. Title plant assets are bought and sold, either in
whole or in part, in exchange transactions or are licensed. Therefore, title plant assets
acquired in a business combination meet the separability criterion. ASC paragraph 805-
20-55-43
Research And Development Assets
Statement 141(R)
B149. This Statement requires an acquirer to recognize all tangible and intangible
research and development assets acquired in a business combination, as was
proposed in the 2005 Exposure Draft. Previously, FASB Interpretation No. 4,
Applicability of FASB Statement No. 2 to Business Combinations Accounted for
by the Purchase Method, required an acquirer to measure and immediately
expense tangible and intangible assets to be used in research and development that
had no alternative future use. A research and development asset was recognized
as such only if it had an alternative future use. …
B150. The FASB concluded that the requirement to immediately write off assets
to be used in research and development activities if they have no alternative future
use resulted in information that was not representationally faithful. In addition,
eliminating that requirement furthers the goal of international convergence of
accounting standards. Therefore, this Statement supersedes Interpretation 4 and
requires research and development assets acquired in a business combination to
be recognized regardless of whether they have an alternative future use.
7.116 Before the issuance of ASC Topic 805, FIN 4 required an acquirer to measure and
immediately expense tangible and intangible assets of an acquiree to be used in research
and development (R&D) activities, unless such assets had an alternative future use. ASC
Topic 805 nullifies FIN 4 and requires all R&D assets acquired in a business combination
to be recognized at the acquisition date at their acquisition-date fair value, regardless of
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
whether they have an alternative future use. See the discussion of Research and
Development Activities below and the discussion of the fair value measurement of
research and development assets in Section 17.
Research and Development Activities
7.117 The ASC Master Glossary defines research and development as follows:
Research is planned search or critical investigation aimed at discovery of new
knowledge with the hope that such knowledge will be useful in developing a new
product or service (referred to as product) or a new process or technique (referred
to as process) or in bringing about a significant improvement to an existing
product or process.
Development is the translation of research findings or other knowledge into a plan
or design for a new product or process or for a significant improvement to an
existing product or process whether intended for sale or use. It includes the
conceptual formulation, design, and testing of product alternatives, construction
of prototypes, and operation of pilot plants.
ASC paragraphs 730-10-15-4(d) through 15-4(e) state that it does not apply to routine or
periodic alterations to existing products, production lines, manufacturing processes, and
other ongoing operations even though those alterations may represent improvements nor
to market research or market testing activities.
7.118 ASC Section 730-10-55 provides the following examples of activities that typically
would be included or excluded from R&D activities:
Example 7.19: Activities That Typically Would Be Included in Research and
Development Activities
a. Laboratory research aimed at discovery of new knowledge.
b. Searching for applications of new research findings or other knowledge.
c. Conceptual formulation and design of possible product or process alternatives.
d. Testing in search for or evaluation of product or process alternatives.
e. Modification of the formulation or design of a product or process.
f. Design, construction, and testing of pre-production prototypes and models.
g. Design of tools, jigs, molds, and dies involving new technology.
h. Design, construction, and operation of a pilot plant that is not of a scale
economically feasible to the enterprise for commercial production.
i. Engineering activity required to advance the design of a product to the point
that it meets specific functional and economic requirements and is ready for
manufacture.
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
j. Tools used to facilitate research and development or components of a product
or process that are undergoing research and development activities.
ASC paragraph 730-10-55-1
Example 7.20: Activities That Typically Would Be Excluded from Research
and Development Activities
a. Engineering follow-through in an early phase of commercial production.
b. Quality control during commercial production including routine testing of
products.
c. Trouble-shooting in connection with breakdowns during commercial
production.
d. Routine, ongoing efforts to refine, enrich, or otherwise improve on the
qualities of an existing product.
e. Adaptation of an existing capability to a particular requirement or customer’s
need as part of a continuing commercial activity.
f. Seasonal or other periodic design changes to existing products.
g. Routine design of tools, jigs, molds, and dies.
h. Activity, including design and construction engineering, related to the
construction, relocation, rearrangement, or start-up of facilities or equipment
other than (1) pilot plants, and (2) facilities or equipment whose sole use is for
a particular research and development project.
i. Legal work in connection with patent applications or litigation, and the sale or
licensing of patents.
ASC paragraph 730-10-55-2
Research Performed for Others under Contractual Arrangements
7.119 Costs associated with performing R&D activities for others under a contractual
arrangement are not R&D activities within the scope of ASC Subtopic 730-10. Indirect
costs that specifically are reimbursable under the terms of a contract also are excluded
from the scope of ASC Subtopic 730-10. ASC paragraph 730-10-15-4(a)
Completed Research and Development Activities
7.120 Identifiable assets resulting from R&D activities of an acquiree might include
patents received or applied for, blueprints, formulas, and specifications or designs for
new products or processes. These assets also include assets referred to in practice as core
technology and/or base technology. As discussed in this Section, the acquirer recognizes
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
any such assets arising from an acquisition separately from goodwill, measured at their
acquisition-date fair value.
In-Process Research And Development Activities
7.121 R&D projects that are underway but have not been completed are referred to as in-
process research and development (IPR&D).
IPR&D Activities Are Subject to ASC Topic 805’s Recognition Principle
7.122 ASC Topic 805 provides no exception to the recognition principle for IPR&D
assets. IPR&D projects acquired in a business combination that meet the definition of an
asset in Concepts Statement 6 at the acquisition date are recognized by the acquirer at
their acquisition-date fair value.
7.123 Paragraph not used.
Identifying Research and Development Assets
7.124 Determining what constitutes an asset used in R&D and measuring its fair value
can be difficult. To provide guidance in this area, the AICPA formed a Task Force to
develop an AICPA Accounting and Valuation Guide, Assets Acquired to Be Used in
Research and Development Activities (IPR&D Guide). The IPR&D Guide was issued in
December 2013 to identify leading practices in the financial reporting of assets acquired
to be used in R&D activities, including specific IPR&D projects. The Task Force noted
that business combinations involving the software, electronic devices, and
pharmaceutical industries have traditionally exhibited the greatest proportional amount
(in terms of total value) of assets acquired to be used in R&D activities. Accordingly, the
IPR&D Guide focuses on those industries. Although the IPR&D Guide has no
authoritative status, its guidance has been used as a resource by preparers, valuation
professionals, and auditors in all industries in identifying, valuing, and reporting IPR&D
assets acquired in a business combination.
7.125 The IPR&D Guide reflects guidance in ASC Subtopic 820-10 and ASC Topic 805.
ASC Subtopic 820-10 provides a framework for measuring fair value when accounting
pronouncements require or permit fair value measurements. See Sections 16 through 21
for a discussion of fair value measurements in accordance with ASC Subtopic 820-10,
including the fair value measurement of IPR&D. ASC Topic 805 addresses the
accounting for business combinations, and as part of that guidance discusses R&D assets
acquired in a business combination.
7.126 ASC Subtopic 820-10 requires a market participant perspective to be used in
measuring fair value of assets acquired and liabilities assumed in a business combination.
Therefore, it is helpful to consider a market participant’s perspective when identifying
IPR&D assets. We believe that if an IPR&D project of an acquiree is expected to have
value to a market participant, it would most likely meet the definition of an asset and
therefore qualify for recognition by the acquirer at the acquisition date.
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
Q&A 7.1: Initial Measurement – IPR&D in a Development Arrangement
In 20X7, BioTech Corp. acquires PharmaDev Corp., which has a development
arrangement with LabTest, Inc. that entitles each party to 50% of any future cash flows
associated with the development, marketing, and sale of a pharmaceutical product.
Q. Does the right to 50% of the future cash flows from the IPR&D project constitute an
identifiable asset in a business combination?
A. Yes. ASC paragraph 805-20-25-10 states that an intangible asset is identifiable if it
meets the separability criterion or the contractual-legal criterion described in the
definition of identifiable in the glossary to ASC Topic 805. In this case, PharmaDev’s
right to 50% of the expected cash flows from IPR&D meets the contractual-legal
criterion to be recognized as an identifiable intangible asset.
Q&A 7.2: Subsequent Measurement – IPR&D in a Development
Arrangement
In 20X8, BioTech Corp. acquires LabTest, Inc., including the other 50% of the future
cash flows associated with the IPR&D asset referenced in Q&A 7.1. The IPR&D project
is an intangible asset that will be measured and recognized at fair value as of the 20X8
acquisition date.
Q. What effect, if any, will the 20X8 acquisition of the remaining rights to the IPR&D
asset have on the existing carrying amount of PharmaDev Corp.’s IPR&D rights acquired
in 20X7?
A. The initial intangible asset acquired in 20X7 and the intangible asset acquired in 20X8
should be evaluated as two distinct intangible assets. Specifically:
• A fair value for the additional 50% rights to IPR&D acquired in 20X8 less
than the carrying amount of the 50% acquired in 20X7 is an indication that the
carrying amount of the 20X7 intangible asset is not recoverable (triggering
event) and should be evaluated for impairment.
• A fair value of the additional 50% right to IPR&D acquired in 20X8 greater
than the carrying amount of the 50% acquired in 20X7 does not cause a
revaluation (write-up) of the 20X7 IPR&D intangible.
7.127 Following is a discussion of additional guidance included in the IPR&D Guide and
its relationship to the guidance in ASC Subtopic 820-10 and ASC Topic 805.
An IPR&D Asset Is Recognized Only if an IPR&D Project Has Substance and Is
Incomplete
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
7.128 The IPR&D Guide indicates, in addition to satisfying the general recognition
criteria applicable to assets acquired in a business combination to be used in R&D
activities, if the asset to be used in R&D activities is a specific IPR&D project,
persuasive evidence should exist that each acquired IPR&D project has substance and is
incomplete:
• Substance - For a specific IPR&D project of an acquired company to give rise
initially to an IPR&D asset, the acquired company has performed R&D
activities that constitute more than insignificant efforts and that
• Meet the definition of R&D under ASC Subtopic 730-10 and
• Result in the creation of value
•
Incompleteness - There are remaining risks (e.g., technological or
engineering) or certain remaining regulatory approvals at the date of
acquisition, Overcoming those risks or obtaining the approvals requires that
additional R&D costs are expected to be incurred after the acquisition.
The IPR&D Guide indicates that, at some point before commercialization and
possibly before the end of the development or the pre-production stage, the R&D
project is no longer incomplete for accounting purposes. If the project is
complete, it is an intangible asset separate and apart from R&D activities.
IPR&D Guide Q&As Illustrating the Assessment of Whether an IPR&D Project Is
Incomplete
7.129 The following Q&As taken from the IPR&D Guide illustrate the assessment of
whether an IPR&D project is incomplete.
Example 7.21: The IPR&D Guide Q&A, par. 2.60: Specific R&D Projects –
Incompleteness
Q. Company T was acquired in a business combination and had an IPR&D project to
develop the next generation of its microchip. The project was estimated to be 70 percent
complete in terms of costs incurred. Although time-consuming and expensive
technological and engineering hurdles remain, they are not believed to be high-risk
development issues and are not considered particularly difficult to accomplish. In fact, in
similar previous development efforts, Company T consistently demonstrated that it could
accomplish the remaining tasks once it got to a similar stage of completion. However, the
remaining tasks are of the type described as R&D activities in ASC paragraph 730-10-55-
1, rather than of the type of activities described in ASC paragraph 730-10-55-2 that are
not considered R&D activities. Is the project incomplete?
A. Yes, because first customer acceptance of the microchip has not occurred. Even
though the likelihood of success in achieving first customer acceptance may seem high
based on Company T’s history, first customer acceptance has not occurred, and additional
qualifying R&D costs will be incurred. Consequently, completion of the project has not
occurred at the date of acquisition.
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Example 7.22: The IPR&D Guide Q&A, par. 2.61: Specific R&D Projects –
Incompleteness
Q. Company A acquires Company T in a business combination. At the acquisition date,
Company T has an R&D project in process to develop the next generation of its job
scheduling software. Company T has delivered a working model of the software to
several of its customers as part of the beta test stage. As of the acquisition date, engineers
are working to incorporate improvements discovered as a result of the beta testing.
Company A expects to complete the development and market any resulting product in a
manner generally consistent with the plans of Company T that existed at the acquisition
date. Is the project incomplete?
A. Yes. The Task Force notes that although the project may have reached technological
feasibility as discussed in ASC Subtopic 985-20, in this fact pattern the project is still
incomplete. As discussed in ASC paragraph 985-20-25-2, "the technological feasibility of
a computer software product is established when the entity has completed all planning,
designing, coding, and testing activities that are necessary to establish that the product
can be produced to meet its design specifications including functions, features, and
technical performance requirements." Despite reaching technological feasibility,
additional research or development, or both, may be required for the product to be
available for general release to customers. Conversely, if after reaching technological
feasibility, this project required only minor, routine modifications prior to general release
to customers, and the general release was imminent, this project would generally be
considered to be completed.
Example 7.23: The IPR&D Guide Q&A, par. 2,62: Specific R&D Projects –
Incompleteness
Q. Company A acquires Company T in a business combination. At the acquisition date,
Company T has an application to market a new drug pending FDA approval. Both
Company A and Company T believe that Company T completed all necessary tasks
related to the filing (including having obtained satisfactory test results), and they believe
that they will ultimately obtain FDA approval. Is the project incomplete?
A. Yes. Industry experience shows that there are uncertainties about obtaining approval
for a new drug on filing with the FDA. ASC Subtopic 730-10 does not specifically
address whether costs of obtaining FDA approval are R&D; however, the Task Force
believes that such future expenditures satisfy the condition that, to be considered
incomplete, additional R&D costs must be expected to be incurred by the reporting
entity.
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the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
Example 7.24: The IPR&D Guide Q&A, par. 2.63: Specific R&D Projects –
Incompleteness
Q. Company T is acquired in a business combination and is involved in the design,
manufacture, and marketing of consumer video communications devices. Company T has
a successful product in the market and has been working on the next generation of the
product, which involves significant improvements to features and functions. Given the
target market of young retail consumers, Company T plans to debut the new product at an
upcoming trade show, followed shortly after by a nationwide marketing campaign. For
competitive reasons, Company T does not allow prototypes of the product outside of its
facilities, although it does use focus groups representing its target market demographics
for feedback on design and features, product and performance quality, and marketing
approaches. As of the acquisition date, Company T has approved the design and
specifications of the latest prototype of new product as being ready for commercial
manufacture. As a result, Company T’s production facilities are preparing to begin mass
production of the product intended for commercial sale. However, Company T has yet to
finalize specifications of the product shell (e.g., color, ergonomic design, and brand
graphics), which are still being tested with focus groups. Commercial manufacturing has
not yet begun, and no products have been sold. Is the project incomplete?
A. No. The R&D project related to the significant improvement of the existing product
has been completed, and there are no remaining R&D costs to be incurred. The remaining
tasks before commercial manufacture and product launch do not involve technological or
engineering risks, and the associated costs would not qualify as R&D. Although first
customer acceptance has not occurred, Company T has demonstrated an equivalent
internal milestone based on its product development practices and life cycle.
7.130 An IPR&D Asset Must Have Substance. The IPR&D Guide indicates that an
IPR&D asset will have substance, meaning that the acquirer performed more than
insignificant efforts that (a) meet the definition of R&D under ASC Subtopic 730-10, and
(b) result in the creation of value. We believe that the examples included in the IPR&D
Guide show that the Task Force’s objective in including this criterion was to specify a
threshold at which sufficient work had been done for IPR&D to be separately identified.
If that threshold is not met, the value otherwise attributable to IPR&D would be
subsumed into goodwill unless it meets the general recognition criteria for intangible
assets. See discussion of the contractual/legal and separability criteria in this Section
under Recognition of Intangible Assets Separately from Goodwill.
7.131 The IPR&D Guide addresses four phases of a project’s life cycle that might be
helpful in determining when a project has substance or whether it has been completed. In
the earlier phases, the attribute of substance evolves to the point at which substance can
be demonstrated, while in the later phases the project gradually reaches a point at which it
is no longer considered incomplete. The four phases of a project’s life cycle identified in
the IPR&D Guide include:
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
a. Conceptualization. This phase entails coming up with an idea, thought, new
knowledge, or plan for a new product, service, or process, or for a significant
improvement to an existing product, service, or process, or it may represent a
decision by a company to focus its research activities within certain core
competencies. Management might make an initial assessment of the potential
market, cost, and technical issues for ideas, thoughts, or plans to determine
whether the ideas can be developed to produce an economic benefit.
b. Applied research. This phase represents a planned search or critical
investigation aimed at the discovery of additional knowledge in hopes that it
will be useful in defining a new product, service, or process that will yield
economic benefits, or significantly improve an existing product, service, or
process that will yield economic benefits. In addition, work during this phase
assesses the feasibility of completing successfully the project and the
commercial viability of the resulting expected product, service, or process.
c. Development. This phase represents the translation of research findings or
other knowledge into a detailed plan or design for a new product, service, or
process, or for a significant improvement to an existing product, service, or
process, and carrying out development efforts pursuant to the plan.
d. Pre-production. This phase represents the business activities necessary to
commercialize the asset resulting from R&D activities for the enterprise’s
economic benefit. The IPR&D Guide, par. 2.45
7.132 The IPR&D Guide lists factors that may demonstrate that a specific IPR&D project
has substance:
• The business was acquired to obtain the project, or the project constituted a
significant part of the business acquired.
• Management considered the impact of potential competition and other factors
(i.e., existing patents that would block plans for further development and
commercialization) on the potential economic benefits of the project.
• Management has approved continued project funding.
• Management can make reasonably reliable estimates of the project’s
completion date.
• Management can make reasonably reliable estimates of costs to complete the
project.
7.133 No single factor is necessarily determinative and judgment will often be needed in
evaluating whether a specific IPR&D project has substance.
The IPR&D Guide Q&As Illustrating the Assessment of Whether an IPR&D
Project Has Substance:
7.134 The following IPR&D Guide Q&As illustrate the assessment of whether an
IPR&D project has substance.
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the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
Example 7.25: The IPR&D Guide Q&A, par. 2.51: Specific R&D Projects –
Substance
Q. Company A, a pharmaceutical company, acquires Company T, a biotechnology
company engaged in cancer R&D, in a business combination. Company T is developing a
small molecule compound thought to have a therapeutic application in the cancer market.
Company T incurs R&D costs in (a) screening approximately 5,000 compounds, (b)
identifying a lead compound, and (c) determining that the lead compound has the desired
effect on the biological target (a part of the body, such as a protein, receptor, or gene, or
something foreign to the body, such as a bacteria or virus, that appears to play an
important role in causing certain diseases) whose function is understood and has been
validated. The lead compound is considered a potential drug development candidate and
Company T has gathered sufficient scientific data to decide to advance this compound to
phase I clinical testing (i.e., testing in humans). Based on Company T’s understanding of
the biological target’s function and scientific data available in the public domain,
Company T is able to make general predictions on potential therapeutic benefits in
treating several types of cancer and potential side effects of the compound, if successful.
The activities already undertaken by Company T have resulted in R&D expenses
incurred. A multi-tumor cancer drug represents a significant market opportunity.
Although no detailed market research has been conducted, market projections have been
prepared based on patient population and cancer incidence rates. Patent searches have
been completed with no patents found that would block Company T’s plans for further
development and commercialization of the compound. In addition, Company T has filed
for patent protection of this compound. Have sufficient R&D activities been undertaken
for this small molecule program such that at the acquisition date the acquired IPR&D
project has substance?
A. Yes. The compound that may lead to a possible drug development candidate has
progressed far enough through the R&D life cycle to have substance. Company T has
selected a specific biological target whose function is understood and has been well
validated. Company T has determined that the lead compound has the desired effect on
the biological target and does not interact with other tissues in the body. Consequently, it
is reasonable to anticipate that this compound may lead to a drug for treating cancer.
Company T has gathered enough scientific data to decide to advance this compound to
phase I clinical testing. Market potential can be reasonably estimated because incidence
of cancer by tumor type is well documented and tracked by several reputable independent
organizations. Market share for a particular compound can be estimated by reviewing
data currently available in the public domain that tracks patented programs by biologic
target from preclinical testing through market launch. Thus, Company T can determine
the number of competitors conducting research on a particular biologic target and
estimate the potential order of entry, given the competitors’ stages of development. When
evaluating whether the acquired IPR&D project has substance, Company T would also
need to consider other factors enumerated in Paragraph 7.132 and other relevant
circumstances.
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Example 7.26: The IPR&D Guide Q&A, par. 2.52: Specific R&D Projects –
Substance
Q. Company A acquires Company T in a business combination. Company T designs and
markets switches for sale to telecom companies, which use the switches to route
telephone communications through their systems. Company T developed a routing
technology for a switch that it believes will be pivotal in creating the next generation of
switches to route Internet and video data over telephone systems (that is, it had completed
the conceptualization and applied research phases of the project). Before the acquisition,
Company T surveyed several telecom companies to assist in designing the specifications
of the proposed switch. In addition, Company T had a documented plan for development
of the switches, which it expected to be complete in 18 months. As of the date of the
acquisition, the development of the switches was underway. Have sufficient R&D
activities been undertaken such that, at the date of acquisition the specific IPR&D project
has substance?
A. Yes. As of the date of the acquisition, Company T had completed the
conceptualization and applied research phases of the project and was partially through
development of the new switch. As a result, the project satisfied the attribute of
substance.
Example 7.27: The IPR&D Guide Q&A par. 2.53: Specific R&D Projects –
Substance
Q. Company A acquires Company T in a business combination. Company T is an
established contract manufacturer of electronic components. An important aspect of its
manufacturing process involves extruding copper wire into extremely fine strands. The
R&D department of Company T has as one of its top priorities improving this aspect of
the manufacturing process. The basic objective of the project would involve significant
improvements to the current process that would further reduce the diameter of the copper
strands without significantly increasing manufacturing costs (e.g., through lower yields of
acceptable material or increased consumption of energy and indirect materials). As of the
date of the acquisition, Company T’s R&D personnel had begun studying possible
technological improvements to the extrusion process by researching relevant technical
and academic material in the public domain. Company T’s R&D personnel also
conducted an all-day brainstorming session in which a number of theoretical approaches
were debated. As a result of that meeting, a consensus on the most promising approach
was identified and a project plan was being drafted that would define expected timing,
resource requirements, and key technical issues of the R&D project. Company T believes
that the project has a fairly high likelihood of success. Have sufficient R&D activities
been undertaken such that, at the acquisition date, the specific IPR&D project has
substance?
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the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
A. No. At the date of the acquisition, Company T’s R&D project had only been
conceptualized. Company T had not expended a more than insignificant effort in R&D
activities to advance existing knowledge and technology toward the project objective. As
a result, although the project concept was promising, the project lacked substance at the
acquisition date and would not qualify to be recognized as an asset.
In-Process Research and Development Assets That an Acquirer Does Not Intend to
Actively Use
ASC Paragraph 805-20-30-6
To protect its competitive position, or for other reasons, the acquirer may intend
not to use an acquired nonfinancial asset actively, or it may not intend to use the
asset according to its highest and best use. For example, that might be the case for
an acquired research and development intangible asset that the acquirer plans to
use defensively by preventing others from using it. Nevertheless, the acquirer
shall measure the fair value of the nonfinancial asset in accordance with [ASC]
Subtopic 820-10 assuming its highest and best use by market participants in
accordance with the appropriate valuation premise, both initially and for purposes
of subsequent impairment testing.
7.135 A business combination may result in the acquisition of IPR&D or other intangible
assets that the acquirer does not intend to actively use (commonly referred to as defensive
intangible assets or locked-up assets). While such assets are not being actively used, they
are likely contributing to an increase in the value of other assets owned by the acquirer.
7.136 ASC Topic 805 and ASC Subtopic 820-10 require that defensive intangible assets
be recognized at a value that reflects the asset’s highest and best use based on market
participant assumptions. See discussion of Assets That the Acquirer Intends Not to Use or
to Use in a Way Other Than Their Highest and Best Use in this Section.
7.137 Subsequent to an acquisition, the acquirer accounts for acquired IPR&D assets in
accordance with ASC paragraphs 350-30-35-15 through 35-17A. See the discussion of
Defensive Intangible Assets in Section 12, Subsequent Measurement and Accounting.
Considerations for Financial Services Entities – Customer-Related Intangible
Assets
7.138 An acquisition of a financial institution may include many of the types of
intangible assets discussed previously. Because services performed by financial
institutions are based on contractual relationships with the institution’s customers, there
are many types of customer-related intangible assets present in acquisitions of financial
institutions. To ensure that all identifiable intangible assets are recognized, careful
consideration should be given to the customer relationship from which projected cash
flows originate. Contractual- and noncontractual-based customer-related intangible assets
unique to a financial institution include:
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
• Core Deposit
• Borrower Base
• Credit-Card Customer-Based
• Mortgage Loan Servicing Rights
• Trust Services
• Private Banking Customer
• Asset Management and Advisory
• Brokerage
• Customer Information Databases
RECOGNIZING ANY NONCONTROLLING INTEREST IN AN
ACQUIREE
7.139 As discussed in Section 2, a business combination occurs when an acquirer obtains
control of one or more businesses. Applying the acquisition method requires that, at the
acquisition date, the identifiable assets acquired and liabilities assumed in an acquisition
be recognized and measured by the acquirer in accordance with ASC Topic 805 (i.e., full
step-up), and that any noncontrolling interest in the acquiree be measured and recognized
at fair value. Noncontrolling interest includes only financial instruments issued by an
acquired subsidiary that are classified as equity in the subsidiary’s financial statements.
Example 7.28: Recognizing Noncontrolling Interest at Fair Value
On December 31, 20X0, ABC Corp. acquires 60% percent of DEF Corp. for cash of
$1,100 (which includes a control premium). The amount of the identifiable net assets of
DEF Corp., measured in accordance with ASC Topic 805, is $1,400. The fair value of the
noncontrolling interest (i.e., the equity of DEF not acquired by ABC) is $600.
Under ASC Topic 805, ABC recognizes the identifiable net assets of DEF at $1,400 (full
step-up to amounts measured in accordance with ASC Topic 805), the noncontrolling
interest at its fair value of $600, and the resulting goodwill at $300 ($1,100 + $600 -
$1,400). The net effect of the acquisition of DEF is recognized in ABC’s consolidated
financial statements as of December 31, 20X0 as follows:
Debit Credit
Identifiable net assets of DEF
Goodwill*
1,400
300
Equity (noncontrolling interest)
Cash
600
1,100
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
*Although presented as one financial statement caption on the parent's balance sheet, if
goodwill is subsequently determined to be impaired, the impairment loss is required to be
attributed to the parent and the noncontrolling interest on a rational basis. The goodwill
attributable to ABC is $260 (($1,100 - (60% × $1,400)), and the goodwill attributable to
the noncontrolling interest is $40 (($600 - (40% × $1,400). The subsequent impairment
loss might be attributed to ABC on the basis of $260/$300, and to the noncontrolling
interest on the basis of $40/$300. See KPMG Handbook, Impairment of nonfinancial
assets, for further discussion on goodwill impairment testing and disposal of all or a
portion of a reporting unit when the reporting unit is less than wholly owned.
MEASUREMENT PRINCIPLE4
ASC Paragraph 805-20-30-1
The acquirer shall measure the identifiable assets acquired, the liabilities assumed,
and any noncontrolling interest in the acquiree at their acquisition-date fair values.
4 See discussion of the exceptions to this principle in this Section under Exceptions to the Recognition and
Measurement Principles. These exceptions relate to assets and liabilities arising from contingencies,
deferred tax assets and liabilities and uncertain tax positions, indemnification assets, employee benefits,
reacquired rights, share-based payment awards, and assets held for sale.
7.140 ASC Topic 805 requires an acquirer to measure the identifiable assets acquired,
liabilities assumed, and any noncontrolling interest in the acquiree at their acquisition-
date fair values, with limited exceptions, which are discussed in this Section under
Exceptions to the Recognition and Measurement Principles. ASC Topic 805 does not
provide guidance on how to determine fair values, but instead states that fair value is
determined in accordance with ASC Subtopic 820-10. See Sections 16 through 21 on Fair
Value Measurements, for additional guidance on the fair value measurement of assets
acquired and liabilities assumed and any noncontrolling interest in the acquiree.
7.141 In applying the fair value measurement guidance of ASC Subtopic 820-10,
acquirer-specific intent on how an acquired asset will be used is not considered in
determining its fair value. Rather, ASC Subtopic 820-10 requires that fair value be
determined using a market participant’s perspective, rather than the acquirer’s specific
planned use or non-use of an acquired asset. See discussion in this Section of Assets That
the Acquirer Intends Not to Use or to Use in a Way Other Than Their Highest and Best
Use.
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
APPLICATION GUIDANCE RELATED TO MEASURING THE FAIR
VALUES OF PARTICULAR IDENTIFIABLE ASSETS AND A
NONCONTROLLING INTEREST IN AN ACQUIREE
ASSETS WITH UNCERTAIN CASH FLOWS (VALUATION ALLOWANCES)
7.141a Measuring financial instruments acquired in a business combination is affected by
ASU 2016-13, Measurement of Credit Losses on Financial Instruments, which
established ASC Topic 326, Financial Instruments—Credit Losses. The table below
provides the mandatory adoption dates for ASC Topic 326 as amended by ASU 2019-10,
Financial Instruments—Credit Losses (Topic 326), Derivatives and Hedging (Topic 815),
and Leases (Topic 842): Effective Dates.
Annual and interim periods beginning
after…
Public business entities that are SEC
filers, excluding entities eligible to be
smaller reporting companies as defined by
the SEC
December 15, 2019
All other entities
December 15, 2022
Early adoption is permitted for fiscal years beginning after December 15, 2018.
7.141b See chapter 25 of KPMG Handbook, Financial instruments: Credit impairment,
for detailed information about the effective date, early adoption, and transition
requirements of ASC Topic 326. See section 12.3 of that Handbook for guidance on
measuring financial assets acquired in a business combination after adopting ASC Topic
326. The remainder of this section addresses measuring assets with uncertain cash flows
before adopting ASC Topic 326.
(Pre-ASC Topic 326) ASC Paragraph 805-20-30-4
The acquirer shall not recognize a separate valuation allowance as of the
acquisition date for assets acquired in a business combination that are measured at
their acquisition-date fair values because the effects of uncertainty about future
cash flows are included in the fair value measure. For example, because this
Subtopic requires the acquirer to measure acquired receivables, including loans, at
their acquisition-date fair values, the acquirer does not recognize a separate
valuation allowance for the contractual cash flows that are deemed to be
uncollectible at that date.
7.142 Separate valuation allowances for receivables acquired in a business combination
are not recognized at the acquisition date, as the effects of uncertainty about future cash
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
flows are considered in the measurement of fair value. However, ASC Topic 805 requires
that the acquirer disclose, for each business combination that occurs during a reporting
period, separately for acquired receivables that are not subject to the requirements of
ASC Subtopic 310-30, Receivables - Loans and Debt Securities Acquired with
Deteriorated Credit Quality, the fair value of the receivables, the gross contractual
amounts receivable, and the best estimate at the acquisition date of the contractual cash
flows not expected be collected. These disclosures are required for each major class of
receivables, such as loans, direct finance leases, and any other class of receivables. ASC
paragraph 805-20-50-1(b)
Example 7.29: Acquired Trade Receivables – Valuation Allowance
Q. ABC Corp. acquires DEF Corp. in a business combination. At the acquisition date,
ABC determines that the trade accounts receivable acquired from DEF of $2,000 had a
fair value of $1,800. The $200 difference between the contractual amount and the fair
value of the trade receivables was attributed to the estimated credit risk of $180 (i.e.,
estimated uncollectible accounts), and a reduction of $20 to reduce the receivables
expected to be collected to their present value, using an appropriate interest rate. How
should ABC reflect the trade receivables in its acquisition accounting?
A. ABC should recognize the acquired trade receivables at their acquisition-date fair
value of $1,800, with no associated valuation allowance. Based on ASC paragraph 805-
20-50-1(b), ABC would disclose in its financial statements the fair value of the
receivables, the gross contractual amounts of the receivables, and the best estimate at the
acquisition date of the contractual cash flows not expected to be collected.
Subsequent to the acquisition, ABC would accrete the $20 discount to income using the
interest method. Accounting for the difference between actual collections and the
amounts recognized at the acquisition date, as well as determining whether an allowance
for uncollectible accounts is necessary in the postcombination period, will depend on
subsequent assessments of collectibility and the units of account identified by the
acquirer for the acquired receivables.
(PRE-ASC TOPIC 8422) ASSETS SUBJECT TO OPERATING LEASES IN WHICH
THE ACQUIREE IS THE LESSOR
7.143 ASC Topic 805 requires that an acquirer recognize and measure the acquisition-
date fair value of an asset subject to an operating lease in which the acquiree is the lessor,
such as a building or a patent or other intangible asset, at its acquisition-date fair value
separately from the lease contract. The acquirer recognizes a separate intangible asset or
liability if the terms of the related operating lease are favorable or unfavorable relative to
market terms. Therefore, the fair value of the leased asset would be the same regardless
of whether it is subject to an operating lease. (ASC paragraph 805-20-30-5; Statement
141(R), par. B147) The acquirer would also recognize an asset or liability for a favorable
or unfavorable contract to the extent the terms of the operating lease are favorable or
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221
7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
unfavorable to the lessor (acquiree) relative to market terms. See discussion of Assets
Subject to Operating Leases When the Acquiree Is the Lessor under Lease Contracts in
this Section.
ASSETS THAT THE ACQUIRER INTENDS NOT TO USE OR TO USE IN A WAY
OTHER THAN THEIR HIGHEST AND BEST USE
ASC Paragraph 805-20-30-6
To protect its competitive position, or for other reasons, the acquirer may intend
not to use an acquired nonfinancial asset actively, or it may not intend to use the
asset according to its highest and best use. For example, that might be the case for
an acquired research and development intangible asset that the acquirer plans to
use defensively by preventing others from using it. Nevertheless, the acquirer
shall measure the fair value of the nonfinancial asset in accordance with [ASC]
Subtopic 820-10 assuming its highest and best use by market participants in
accordance with the appropriate valuation premise, both initially and for purposes
of subsequent impairment testing.
7.144 A business combination may result in the acquisition of assets, including IPR&D
or other intangible assets, that the acquirer does not intend to actively use, or intends to
use in a way that is not its highest and best use (these assets are commonly referred to as
defensive assets or locked-up assets). While such assets are not being actively used, they
are likely contributing to an increase in the value of other assets owned by the acquirer.
7.145 Although defensive intangible assets are not actively used by the acquirer, ASC
Topic 805 and ASC Subtopic 820-10 require that defensive intangible assets be
recognized at a value that reflects the asset’s highest and best use based on market
participant assumptions.
Example 7.30: Acquirer Does Not Intend to Use Acquired Trade Name
As part of a business combination, an entity acquires a trade name that it does not intend
to use, but which would provide maximum value to market participants through its use in
combination with other assets. The acquirer should recognize and measure the trade name
at its acquisition-date fair value, using an in-use valuation premise, because in-use is the
highest and best use by market participants.
Example 7.31: Acquired IPR&D the Acquirer Does Not Intend to Use
The reporting entity acquires an IPR&D project in a business combination. The reporting
entity does not intend to complete the IPR&D project. If completed, the IPR&D project
would compete with one of its own IPR&D projects (to provide the next generation of the
reporting entity’s commercialized technology). Instead, the reporting entity intends to
hold (lock up) the IPR&D project to prevent its competitors from obtaining access to the
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
technology. The IPR&D project is expected to provide defensive value, principally by
improving the prospects for the reporting entity’s own competing technology. For
purposes of measuring the fair value of the IPR&D project at initial recognition, the
highest and best use of the IPR&D project would be determined based on its use by
market participants. See ASC paragraph 820-10-55-32 for additional analysis as to
whether the highest and best use of the IPR&D would be in-use or in-exchange.
7.146 See the discussion of In-Process Research and Development Assets that an
Acquirer Does Not Intend to Actively Use, in this Section, and the discussion of
Defensive Intangible Assets in Section 12.
CONTINGENT CONSIDERATION ARRANGEMENTS OF AN ACQUIREE ASSUMED
BY THE ACQUIRER
ASC Paragraph 805-20-30-9A
Contingent consideration arrangements of an acquiree assumed by the acquirer in
a business combination shall be measured initially at fair value in accordance with
the guidance for contingent consideration arrangements in [ASC] paragraph 805-
30-25-5.
7.147 The acquiree may have contingent consideration from one or more of its
acquisitions before being acquired by the acquirer. ASC paragraph 805-20-30-9A
specifies that this is recognized and measured in the same manner as any contingent
consideration agreed to between the acquirer and the acquiree. However, unlike
contingent consideration agreed to between the acquirer and acquiree, which is part of the
consideration transferred (see Section 6), we believe that contingent consideration of the
acquiree is treated as a liability assumed in the acquisition rather than as consideration
transferred. See Paragraph 12.023 for discussion of subsequent accounting for contingent
consideration arrangements of the acquiree assumed by the acquirer.
MEASURING THE FAIR VALUE OF A NONCONTROLLING INTEREST IN AN
ACQUIREE
ASC Paragraphs 805-20-30-7
[ASC] paragraph 805-20-30-1 requires the acquirer to measure a noncontrolling
interest in the acquiree at its fair value at the acquisition date. An acquirer
sometimes will be able to measure the acquisition-date fair value of a
noncontrolling interest on the basis of a quoted price in an active market for the
equity shares (that is, those not held by the acquirer). In other situations, however,
a quoted price in an active market for the equity shares will not be available. In
those situations, the acquirer would measure the fair value of the noncontrolling
interest using another valuation technique.
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
ASC Paragraph 805-20-30-8
The fair values of the acquirer’s interest in the acquiree and the noncontrolling
interest on a per-share basis might differ. The main difference is likely to be the
inclusion of a control premium in the per-share fair value of the acquirer’s interest
in the acquiree or, conversely, the inclusion of a discount for lack of control (also
referred to as a noncontrolling interest discount) in the per-share fair value of the
noncontrolling interest if market participants would take into account such a
premium or discount when pricing the noncontrolling interest.
7.148 Under ASC paragraph 805-20-30-1, noncontrolling interests are measured at fair
value at the date of acquisition. See Section 19 for a discussion of the fair value
measurement of noncontrolling interests.
EXCEPTIONS TO THE RECOGNITION AND MEASUREMENT
PRINCIPLES (PRE-ASC TOPIC 8423)
7.149 ASC Topic 805 provides certain exceptions to the recognition and measurement
principles that are applied at the acquisition date in recognizing and measuring the assets
acquired, liabilities assumed, and any noncontrolling interest in an acquiree.
7.150 The exceptions to the recognition or measurement principles are as follows:
Exceptions to Both the
Recognition and Measurement
Principles
Assets and liabilities arising from
contingencies
Deferred tax assets and liabilities
and tax uncertainties
Employee benefits
Indemnification assets
Exceptions to the
Measurement Principle
Reacquired rights
Share-based payment awards
Assets held for sale
7.151 Assets acquired and liabilities assumed in an acquisition that are subject to these
limited exceptions are recognized and measured in accordance with the specific guidance
provided in ASC Topic 805, rather than based on the general recognition and
measurement principles of ASC Topic 805. ASC paragraphs 805-20-25-16 and 30-10
7.152 Subsequent to a business combination, assets acquired and liabilities assumed or
incurred, and equity instruments issued in the acquisition are generally measured and
accounted for in accordance with the applicable GAAP. However, ASC Topic 805
provides specific guidance on the subsequent measurement and accounting for certain
assets acquired, liabilities assumed, and equity instruments issued in a business
combination, including guidance with respect to most of the items that are subject to the
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
exceptions to the recognition and measurement principles of ASC Topic 805. See the
discussion of Subsequent Measurement and Accounting in Section 12.
Exceptions to Both the Recognition and Measurement Principles
7.153 ASC Topic 805 provides for four exceptions to both its recognition and
measurement principles. Those exceptions are for assets and liabilities arising from
contingencies, deferred tax assets and liabilities and tax uncertainties, indemnification
assets, and employee benefits.
Assets and Liabilities Arising from Contingencies
ASC Paragraph 805-20-25-18A
The following recognition guidance in [ASC] paragraphs 805-20-25-19 through
25-20B applies to assets and liabilities meeting both of the following conditions:
a. Assets acquired and liabilities assumed that would be within the scope of
[ASC] Topic 450 if not acquired or assumed in a business combination
b. Assets or liabilities arising from contingencies that are not otherwise
subject to specific guidance in [ASC Subtopic 805-20].
ASC Paragraph 805-20-25-19
If the acquisition-date fair value of the asset or liability arising from a
contingency can be determined during the measurement period, that asset or
liability shall be recognized at the acquisition date. For example, the acquisition-
date fair value of a warranty obligation often can be determined.
ASC Paragraph 805-20-25-20
If the acquisition-date fair value of the asset or liability arising from a
contingency cannot be determined during the measurement period, an asset or
liability shall be recognized at the acquisition date if both the following criteria
are met:
a. Information available before the end of the measurement period indicates
that it is probable that an asset existed or that a liability had been incurred at
the acquisition date. It is implicit in this condition that it must be probable at
the acquisition date that one or more future events confirming the existence of
the asset or liability will occur.
b. The amount of the asset or liability can be reasonably estimated.
ASC Paragraph 805-20-25-20A
The criteria in the preceding paragraph shall be applied using the guidance in
[ASC] Topic 450 for application of similar criteria in [ASC] paragraph 450-20-
25-2.
ASC Paragraph 805-20-25-20B
If the recognition criteria in [ASC] paragraphs 805-20-25-19 through 25-20A are
not met at the acquisition date using information that is available during the
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
measurement period about facts and circumstances that existed as of the
acquisition date, the acquirer shall not recognize an asset or liability as of the
acquisition date. In periods after the acquisition date, the acquirer shall account
for an asset or a liability arising from a contingency that does not meet the
recognition criteria at the acquisition date in accordance with other applicable
GAAP, including [ASC] Topic 450, as appropriate.
ASC Paragraph 805-20-30-9
[ASC] paragraphs 805-20-25-18A through 25-20B establish the requirements
related to recognition of certain assets and liabilities arising from contingencies.
Initial measurement of assets and liabilities meeting the recognition criteria in
[ASC] paragraph 805-20-25-19 shall be at acquisition-date fair value. Guidance
on the initial measurement of other assets and liabilities from contingencies not
meeting the recognition criteria of that paragraph, but meeting the criteria in
[ASC] paragraph 805-20-25-20 is at [ASC] paragraph 805-20-30-23.
ASC Paragraph 805-20-30-23
Initial measurement of assets and liabilities meeting the recognition criteria in
[ASC] paragraph 805-20-25-20 shall be at the amount that can be reasonably
estimated by applying the guidance in [ASC] Topic 450 for application of similar
criteria in [ASC] paragraph 450-20-25-2.
7.154 Under ASC Topic 805, assets and liabilities arising from contingencies of an
acquiree existing at the acquisition date are evaluated for recognition and measurement
using a two-step process. First, the acquirer needs to consider whether the fair value of an
asset or liability arising from a contingency is determinable. If so, then the asset or
liability is recognized at its fair value at the acquisition date. In making this
determination, the acquirer should consider all information available during the
measurement period that bears on whether the fair value of the contingency was
determinable as of the acquisition date.
7.155 ASC paragraph 805-20-25-19 indicates that the FASB believes that the fair value
of a warranty obligation generally will be determinable and therefore it is expected that
warranty obligations will be measured at fair value by the acquirer in most circumstances.
Apart from warranty obligations, based on discussions with the FASB staff, we
understand that the FASB did not intend to change the guidance on accounting for
contingencies acquired or assumed in a business combination from that which existed
under Statement 141.
7.156 Paragraph 40(a) of Statement 141 contained the following guidance on recognition
of preacquisition contingencies at fair value:
If the fair value of the preacquisition contingency can be determined during the
allocation period, that preacquisition contingency shall be included in the
allocation of the purchase price based on that fair value.
Additionally, footnote 14 attached to paragraph 40(a) stated: “For example, if it can be
demonstrated that the parties to a business combination agreed to adjust the total
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226
7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
consideration by an amount because of a contingency, that amount would be a
determined fair value of that contingency.”
7.157 In practice, the guidance in footnote 14 of Statement 141 is understood to mean
that there is a high threshold to be met when evaluating whether fair value of such
contingencies can be determined. However, paragraph B10 of FSP FAS 141(R)-1,
“Accounting for Assets Acquired and Liabilities Assumed in a Business Combination
That Arise from Contingencies,” states: “In the deliberations leading to this FSP, the
Board decided to adopt a model similar to the guidance in Statement 141 to address the
application issues raised by constituents.” Accordingly, while the Board did not carry
forward footnote 14 into ASC paragraph 805, we believe that the approach taken
previously under Statement 141 continues to be applicable for contingencies arising in a
business combination with the exception of warranty obligations.
7.158 If the fair value of an asset acquired or liability assumed arising from contingencies
is not determinable as of the measurement date (including consideration of all
information available during the measurement period), then the second step is to apply
the probable and reasonably estimable criteria of ASC Topic 450 to the contingency. If
those criteria are met, the contingency is recognized at its estimated amount, including
consideration of the guidance in ASC paragraph 450-20-30-1. If, in applying the second
step, it either is not probable that an asset or liability exists at the acquisition date or the
amount is not reasonably estimable, then the contingency is not recognized in the
acquisition accounting. Contingencies that arise as a result of the acquisition, did not
exist at the acquisition date, or did not meet the recognition criteria at the acquisition
date, are not part of the acquisition accounting and are accounted for separately in
accordance with other applicable GAAP, including ASC Topic 450. See the discussion of
Subsequent Measurement and Accounting in Section 12.
Deferred Tax Assets and Liabilities and Tax Uncertainties
7.159 Deferred tax assets and liabilities that arise as a result of the assets acquired and
liabilities assumed, as well as deductible temporary differences, carryforwards, and any
income tax uncertainties of an acquiree that exist at the acquisition date, should be
recognized and measured in accordance with ASC Topic 740, Income Taxes, including
the guidance on uncertain income taxes. (ASC paragraphs 805-740-25-2 and 30-1) The
FASB decided not to require measurement of deferred tax assets and liabilities at their
acquisition-date fair values because of potential postcombination gains and losses that
may result immediately following the acquisition when applying the measurement
provisions of ASC Topic 740. (Statement 141(R), par. B281; ASC paragraphs 805-740-
25-2 and 30-1) See KPMG Handbook, Accounting for Income Taxes, Section 6 for a
discussion of income tax considerations in a business combination.
Employee Benefits
ASC Paragraph 805-20-25-22
The acquirer shall recognize a liability (or asset, if any) related to the acquiree’s
employee benefit arrangements in accordance with other GAAP. For example,
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7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
employee benefits in the scope of the guidance identified in [ASC] paragraphs
805-20-25-23 through 25-26 would be recognized in accordance with that
guidance and as specified in those paragraphs.
ASC Paragraph 805-20-25-23
Guidance on defined benefit pension plans is presented in [ASC] Subtopic 715-
30. If an acquiree sponsors a single-employer defined benefit pension plan, the
acquirer shall recognize as part of the business combination an asset or a liability
representing the funded status of the plan (see [ASC] paragraph 715-30-25-1).
[ASC] paragraph 805-20-30-15 provides guidance on determining that funded
status. If an acquiree participates in a multiemployer plan, and it is probable as of
the acquisition date that the acquirer will withdraw from that plan, the acquirer
shall recognize as part of the business combination a withdrawal liability in
accordance with [ASC] Subtopic 450-20.
ASC Paragraph 805-20-25-24
The Settlements, Curtailments, and Certain Termination Benefits Subsections of
[ASC] Sections 715-30-25 and 715-30-35 establish the recognition guidance
related to accounting for settlements and curtailments of defined benefit pension
plans and certain termination benefits.
ASC Paragraph 805-20-25-25
Guidance on defined benefit other postretirement plans is presented in [ASC]
Subtopic 715-60. If an acquiree sponsors a single-employer defined benefit
postretirement plan, the acquirer shall recognize as part of the business
combination an asset or a liability representing the funded status of the plan (see
[ASC] paragraph 715-60-25-1). [ASC] paragraph 805-20-30-15 provides
guidance on determining that funded status. If an acquiree participates in a
multiemployer plan and it is probable as of the acquisition date that the acquirer
will withdraw from that plan, the acquirer shall recognize as part of the business
combination a withdrawal liability in accordance with [ASC] Subtopic 450-20.
ASC Paragraph 805-20-25-26
See also the recognition-related guidance for the following other employee benefit
arrangements:
a. One-time termination benefits in connection with exit or disposal activities.
See [ASC] Section 420-10-25.
b. Compensated absences. See [ASC] Section 710-10-25.
c. Deferred compensation contracts. See [ASC] Section 710-10-25.
d. Nonretirement postemployment benefits. See [ASC] Section 712-10-25.
ASC Paragraph 805-20-30-14
The acquirer shall measure a liability (or asset, if any) related to the acquiree’s
employee benefit arrangements in accordance with other GAAP. For example,
employee benefits in the scope of the guidance identified in [ASC] paragraphs
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228
7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
805-20-30-15 through 30-17 would be measured in accordance with that guidance
and as specified in those paragraphs.
ASC Paragraph 805-20-30-15
Guidance on defined benefit pension plans is presented in [ASC] Subtopic 715-
30. Guidance on defined benefit other postretirement plans is presented in [ASC]
Subtopic 715-60. ASC paragraphs 805-20-25-23 and 805-20-25-25 require an
acquirer to recognize as part of a business combination an asset or a liability
representing the funded status of a single-employer defined benefit pension or
postretirement plan. In determining that funded status, the acquirer shall exclude
the effects of expected plan amendments, terminations, or curtailments that at the
acquisition date it has no obligation to make. The projected benefit obligation
assumed shall reflect any other necessary changes in assumptions based on the
acquirer’s assessment of relevant future events.
ASC Paragraph 805-20-30-16
The Settlements, Curtailments, and Certain Termination Benefits Subsections of
[ASC] Section 715-30-35 establish the measurement guidance related to
accounting for settlements and curtailments of defined benefit pension plans and
certain termination benefits.
ASC Paragraph 805-20-30-17
See also measurement-related guidance for the following other employee benefit
arrangements:
a. One-time termination benefits in connection with exit or disposal activities.
See [ASC] Section 420-10-25.
b. Compensated absences. See [ASC] Section 710-10-25.
c. Deferred compensation contracts. See [ASC] Section 710-10-25.
d. Nonretirement postemployment benefits. See [ASC] Section 712-10-25.
7.160 In its deliberations of ASC Topic 805, the FASB concluded that it was not feasible
to require all employee benefit obligations assumed in a business combination to be
measured at their acquisition-date fair values without a comprehensive reconsideration of
the relevant standards for those benefits. The FASB decided to require that such
obligations and related assets be measured in accordance with other applicable standards.
Statement 141(R), par. B299; ASC paragraphs 805-20-25-23 through 25-26
7.161 Certain considerations in the application of other standards at the acquisition date
related to the recognition and measurement of employee benefits as the result of an
acquisition are discussed below.
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229
7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
Pension-Related Assets and Liabilities
Single-Employer Defined Benefit Plans
7.162 ASC Subtopic 715-30 requires the acquirer to recognize, as part of the accounting
for the business combination, an asset or a liability representing the funded status of the
plan. If, at the acquisition date, the fair value of the plan assets exceeds the projected
benefit obligation, an asset is recognized; however, if the projected benefit obligation
exceeds the fair value of the plan assets, a liability is recognized. ASC Subtopic 715-30
requires that the measurement of the funded status of the plan exclude the effects of
expected plan amendments, terminations, or curtailments that the acquirer has no
obligation to make at the acquisition date, and specifies that the projected benefit
obligation assumed shall reflect any other necessary changes in assumptions based on the
acquirer’s assessment of relevant future events. ASC paragraph 805-20-30-15
7.163 An acquirer is required to determine the fair value of the plan assets and the
projected benefit obligation at the acquisition date, and recognize in its accounting for the
acquisition either an asset or a liability, equal to the difference between the fair value of
the plan assets and the projected benefit obligation. The determination of the projected
benefit obligation includes any necessary changes in assumptions based on the acquirer’s
assessment of relevant future events. These events include the actuarial assumptions
necessary to measure the projected benefit obligation (e.g., the discount rate, mortality
assumptions, turnover, and compensation increases).
Example 7.32: Funded Status of a Single-Employer Defined Benefit Pension
Plan of an Acquiree before and after a Business Combination
ABC Corp. acquires DEF Corp. in a business combination on April 30, 20Y0. DEF
sponsored a single-employer defined benefit pension plan. At December 31, 20X9,
DEF’s financial statements reflected a $300 net unfunded obligation and a debit balance
in accumulated other comprehensive income of $100, which represented $75 of
accumulated actuarial losses and $25 of prior service cost not yet recognized in earnings.
In the 4 months ended April 30, 20Y0, DEF recorded $100 of net periodic pension cost in
accordance with ASC Subtopic 715-30. This included $2 of amortization of prior service
cost, no amortization of the actuarial loss (because the amount at the prior year-end was
within the corridor) and $15 of expected return on plan assets. There were no benefits
paid during the period. The funded status of DEF’s plan at the most recent audited
balance sheet date and a rollforward to the acquisition date is:
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230
7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
Projected
Benefit
Obligation
Plan Assets
Funded
Status
AOCI
($1,000)
$700
($300)
$100
($113)
($1,113)
$15
$715
($98)
($398)
($2)
$98
December 31, 20X9
Net periodic pension cost
recorded by DEF in
accordance with ASC
Subtopic 715-30 from
January 1, 20Y0 to April
30, 20Y0
DEF’s pension accounts
as of April 30, 20Y0
The acquisition agreement provides that ABC will continue DEF’s defined benefit
pension plan without any changes. ABC engaged its actuaries to determine the projected
benefit obligation of DEF’s plan as of the acquisition date. Based on updated
measurements of plan assets and benefit obligations, including appropriate changes to
actuarial assumptions, as of April 30, 20Y0, the projected benefit obligation is $1,250. In
addition, ABC obtained information from the plan trustee indicating that the fair value of
plan assets as of that date is $750.
As a result of this information, ABC records a net unfunded pension obligation of $500
related to DEF’s pension plan in its financial statements, comprised of a $1,250 projected
benefit obligation and $750 fair value of plan assets. ABC does not record amounts in
AOCI as of the acquisition date related to actuarial losses or prior service cost that
previously were recorded in DEF’s financial statements.
Example 7.33: Plan Amendments an Acquirer Is Not Required to Make
Assume the same facts as in Example 7.32, except that ABC Corp. plans to make certain
amendments to the DEF plan after the acquisition; however, there is no obligation for
ABC to make the planned amendments.
The determination of the asset or liability representing the funded status of DEF’s plan,
as illustrated in Example 7.32, is not affected by the planned amendments, because ABC
has no obligation to make the amendments. Instead, the amendments, when made, are
accounted for as plan amendments in accordance with ASC Subtopic 715-30. Therefore,
an increase or decrease in the projected benefit obligation (i.e., prior service cost or
negative prior service cost) as a result of the amendments would be initially offset by a
charge or credit to other comprehensive income at the date of the amendment, and
subsequently amortized as a component of net periodic pension cost in accordance with
ASC Subtopic 715-30.
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231
7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
Example 7.34: Employees of Acquiree Included in Pension Plan of Acquirer
Q. If the acquirer includes the employees of the acquiree (which did not have a pension
plan) in its pension plan and grants them credit for prior service, how is the credit granted
for prior service accounted for?
A. If the acquirer’s granting of credit for prior service to the employees of the acquiree is
required to complete the acquisition, it is part of the acquisition and is included in the
acquisition accounting. If the granting of credit for prior service is not a requirement to
complete the acquisition, it is not part of the acquisition and is not included in the
acquisition accounting, but rather is accounted for as a plan amendment in the acquirer’s
postcombination financial statements.
If the credit granted for prior service is part of the acquisition, the debit offsetting the
increase in the projected benefit obligation is an increase in goodwill (or a decrease in the
gain from a bargain purchase) recognized in the acquisition accounting. If the credit
granted for prior service is accounted for as a plan amendment in the acquirer’s
postcombination financial statements, the increase in the projected benefit obligation
resulting from the amendment is included in the projected benefit obligation, with an
offsetting charge to other comprehensive income as prior service cost, and subsequently
amortized as a component of net periodic pension cost. ASC paragraphs 715-30-35-11
and 35-13
Multiemployer Pension Plans
7.164 If the acquiree in a business combination participates in a multiemployer pension
plan and it is probable as of the acquisition date that the acquirer will withdraw from that
plan, the acquirer recognizes as part of the business combination a withdrawal liability in
accordance with ASC Topic 450. ASC paragraph 805-20-25-23
Postretirement Benefits Other Than Pensions
7.165 ASC Subtopic 715-60 specifies the appropriate accounting for other postretirement
benefits-related assets and liabilities of an acquiree. The accounting specified in ASC
Subtopic 715-60 is similar to the accounting required by an acquirer under ASC Subtopic
715-30 when an acquiree sponsors a single-employer defined benefit plan.
Single-Employer Defined Benefit Postretirement Plans
7.166 If an acquiree sponsors a single-employer defined benefit postretirement plan, ASC
Subtopic 715-60 requires the acquirer to recognize as part of the acquisition accounting
an asset or a liability representing the funded status of the plan. The funded status of each
plan is measured as the difference between the fair value of plan assets and the
accumulated postretirement benefit obligation. ASC Subtopic 715-60 was amended by
ASC Topic 805 to specify that the measurement of the funded status of the plan excludes
the effects of expected plan amendments, terminations, or curtailments that at the
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232
7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
acquisition date it has no obligation to make, and requires that the accumulated
postretirement benefit obligation assumed reflects any other necessary changes in
assumptions based on the acquirer’s assessment of relevant future events. ASC paragraph
805-20-30-15
Example 7.35: Postretirement Benefit Plan That Will Be Amended as a
Condition of the Acquisition Agreement
ABC Corp. acquires DEF Corp. in a business combination. DEF sponsors a
postretirement benefit plan that provides postretirement healthcare benefits to its
employees, subject to a $500 annual deductible to be paid by the employees. As a
condition of the acquisition agreement, DEF’s plan is amended to reduce the deductible
to be paid by DEF’s employees to $200 annually.
Because the amendment is a requirement of the acquisition, it is part of the acquisition
and is included in the acquisition accounting. The offset to the increase in the
accumulated postretirement benefit obligation resulting from the amendment would be an
increase in goodwill (or a decrease in the gain from a bargain purchase) recognized in the
acquisition accounting.
Multiemployer Defined Benefit Postretirement Plans
7.167 If an acquiree participates in a multiemployer postretirement plan and it is probable
as of the acquisition date that the acquirer will withdraw from that plan, the acquirer
recognizes a liability related to withdrawal from the multiemployer plan under ASC
Topic 450. ASC paragraph 805-20-25-25
Indemnification Assets
ASC Topic 805-20-25-27
The seller in a business combination may contractually indemnify the acquirer for
the outcome of a contingency or uncertainty related to all or part of a specific
asset or liability. For example, the seller may indemnify the acquirer against
losses above a specified amount on a liability arising from a particular
contingency; in other words, the seller will guarantee that the acquirer’s liability
will not exceed a specified amount. As a result, the acquirer obtains an
indemnification asset. The acquirer shall recognize an indemnification asset at the
same time that it recognizes the indemnified item, measured on the same basis as
the indemnified item, subject to the need for a valuation allowance for
uncollectible amounts. Therefore, if the indemnification relates to an asset or a
liability that is recognized at the acquisition date and measured at its acquisition-
date fair value, the acquirer shall recognize the indemnification asset at the
acquisition date measured at its acquisition-date fair value.
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233
7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
ASC Topic 805-20-30-18
. . . For an indemnification asset measured at fair value, the effects of uncertainty
about future cash flows because of collectibility considerations are included in the
fair value measure and a separate valuation allowance is not necessary as noted in
[ASC] paragraph 805-20-30-4.
ASC Topic 805-20-25-28
In some circumstances, the indemnification may relate to an asset or a liability
that is an exception to the recognition or measurement principles. For example, an
indemnification may relate to a contingency that is not recognized at the
acquisition date because it does not satisfy the criteria for recognition in [ASC]
paragraphs 805-20-25-18A through 25-19 at that date. In those circumstances, the
indemnification asset shall be recognized and measured using assumptions
consistent with those used to measure the indemnified item, subject to
management’s assessment of the collectibility of the indemnification asset and
any contractual limitations on the indemnified amount.
ASC Topic 805-20-40-3
The acquirer shall derecognize an indemnification asset recognized in accordance
with [ASC] paragraphs 805-20-25-27 through 25-28 only when it collects the
asset, sells it, or otherwise loses the right to it.
7.168 The accounting discussed in this Section applies to indemnities related to a specific
asset, liability or contingent liability of the acquiree. It generally does not apply to the
accounting for general representations and warranties because these provisions typically
do not relate to an uncertainty surrounding a specific asset or liability of the acquiree. See
Consideration Held in Escrow for General Representations and Warranties starting at
Paragraph 6.020b for additional discussion about general representations and warranties.
7.169 Acquisition agreements sometimes provide that the seller indemnifies the acquirer
against a particular contingent liability outstanding at the acquisition date. A contingent
liability could relate, for example, to a legal case of the acquiree for environmental
pollution or a tax uncertainty. An indemnification asset arises from the seller’s agreement
to reimburse (indemnify) the acquirer for all or a portion of the ultimate liability resulting
from the resolution of the legal case or the tax uncertainty.
7.170 When the seller is contractually obligated to indemnify a specific liability assumed
by the acquirer, an indemnification asset should be recognized at the same time and
measured using the same measurement basis as the liability, subject to the need for a
valuation allowance for uncollectible amounts. The FASB included this requirement in
ASC Topic 805 to avoid the potential recognition of offsetting gains and losses in
different periods that otherwise might arise if indemnified items and the indemnification
assets were accounted for on different bases. Thus, both the indemnification asset and the
liability are measured on a consistent basis using similar assumptions, subject to any
contractual limitations on the indemnified amount and management’s assessment of
collectibility of the indemnification asset. Therefore, an indemnification asset would be
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234
7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
recognized as of the acquisition date only if the item to which the indemnification relates
is recognized at that date.
7.171 If the indemnification relates to an asset or liability that is recognized at the
acquisition date and measured at fair value on that date, the acquirer also recognizes the
indemnification asset at its acquisition-date fair value. Uncertainties related to
collectibility of the indemnification asset are included in the fair value measurement, and
a separate valuation allowance would not be necessary.
7.172 If the indemnification relates to an asset or liability that is an exception to the
recognition or measurement principles, the indemnification asset is recognized and
measured using assumptions consistent with those used to measure the indemnified item.
For example, if a contingency that is subject to indemnification by the seller is not
recognized at the acquisition date because its fair value is not determinable (which would
be the typical case) and it is not probable and reasonably estimable that a liability existed
at the acquisition date, the indemnification asset would also not be recognized at the
acquisition date. Similarly, if the indemnification relates to an asset or liability that is
measured on a basis other than fair value (e.g., an uncertain tax position that is
recognized in accordance with ASC Topic 740, the related indemnification asset would
be measured using assumptions consistent with those used to measure the indemnified
item, adjusted for management’s assessment of collectibility and any contractual
limitations on the indemnification asset.
7.173 An indemnification asset initially recognized at the acquisition date is subsequently
measured on the same basis as the indemnified liability or asset, subject to any
contractual limitations on its amount and, for an indemnification asset that is not
subsequently measured at fair value, management’s assessment of the collectibility of the
indemnification asset. An indemnification asset is derecognized only when the acquirer
collects it, sells it, or otherwise loses the right to it. See discussion of Indemnification
Assets in Section 12 for additional guidance on the subsequent measurement and
accounting for indemnification assets.
7.173a We believe that indemnification assets are in the scope of ASC Subtopic 326-20,
Financial Instruments—Credit Losses, only when the indemnified item is a financial
asset measured at amortized cost; in that case, see KPMG Handbook, Credit impairment,
for guidance on the recognition and measurement of credit losses. For indemnification
assets that are outside the scope of ASC Subtopic 326-20 and are not measured at fair
value, we believe the acquirer should use ASC Subtopic 450-20, Contingencies - Loss
Contingencies, to account for credit losses.
Example 7.36: Indemnification Asset Related to Noncontractual
Contingency
Q. ABC Corp. acquires DEF Corp. in a business combination. At the acquisition date,
DEF is subject to a legal claim and indemnifies ABC for up to $2,500 in the event of an
unfavorable outcome related to the contingency. ABC determines that, at the acquisition
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235
7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
date, that a liability for the contingency does not meet the recognition criteria of ASC
paragraphs 805-20-25-19 through 25-20. How should ABC account for the
indemnification asset at the acquisition date?
A. Because the contingency (the legal claim) does not meet the recognition criteria at the
acquisition date, it is subject to the recognition exception, as discussed in ASC paragraph
805-20-25-20B and Paragraph 7.150. As a result, a liability for the contingency is not
recognized at the acquisition date.
ASC Topic 805 requires that the indemnification asset be recognized at the same time it
recognizes the indemnified item, measured on the same basis as the indemnified item
(subject to the need for a valuation allowance for uncollectible amounts). Accordingly,
because ABC does not recognize the indemnified item at the acquisition date, it would
also not recognize the indemnification asset at that date.
If ABC subsequently recognizes a liability in its postcombination financial statements for
the liability under ASC Topic 450, it would also recognize an indemnification asset at
that time, measured using the same assumptions as the liability, subject to management’s
assessment of collectibility and contractual limitations on the indemnified amount. See
discussion of Indemnification Assets in Section 12.
EXCEPTIONS TO THE MEASUREMENT PRINCIPLE
Reacquired Rights
ASC Paragraph 805-20-30-20
The acquirer shall measure the value of a reacquired right recognized as an
intangible asset in accordance with [ASC] paragraph 805-20-25-14 on the basis of
the remaining contractual term of the related contract regardless of whether
market participants would consider potential contractual renewals in determining
its fair value.
7.174 An acquirer’s acquisition of a right that was granted previously to an acquiree to
use one of the acquirer’s assets (recognized or unrecognized) is a reacquired right. For
example, the reacquisition in a business combination of a previously granted right to use
the acquirer’s trade name under a franchise agreement or the right to use the acquirer’s
technology are reacquired rights. A reacquired right represents an identifiable intangible
asset that is recognized separately from goodwill as part of the acquisition accounting.
7.175 The FASB observed that a reacquired right is no longer a contract with a third
party and that it would therefore not be appropriate to assume renewals of the contract.
Accordingly, such rights are measured by taking into account only the remaining
contractual terms of the related contract. Potential renewals are ignored even if a market
participant considers potential contract renewals in the determination of fair value.
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236
7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
7.176 If the terms of the contract giving rise to a reacquired right are favorable or
unfavorable relative to current market transactions for the same or similar items, the
acquirer recognizes a gain or loss on the effective settlement of the preexisting
relationship. (ASC paragraph 805-20-25-15) See discussion of Preexisting Relationships
in Section 11.
Example 7.37: Reacquired Right
On January 1, 20Y0, ABC Corp. granted DEF Corp. (which is a business) an exclusive
right to sell products under ABC’s brand name in a specified geographical area for 10
years. ABC subsequently acquires DEF on January 1, 20Y3. As a result, ABC has
reacquired a right that it previously had granted to DEF, and ABC can now sell its
products under its brand in the specified geographical area. ABC should recognize an
intangible asset for this reacquired right at the acquisition date, measured at fair value
based on the seven years remaining in the contract. Additionally, if the terms of the
existing contract between ABC and DEF are favorable or unfavorable relative to market
terms, a gain or loss on the effective settlement of the preexisting contract should also be
recognized.
See Section 12 for a discussion of the subsequent accounting and measurement for
reacquired rights.
Share-Based Payment Awards
ASC Paragraph 805-20-30-21
The acquirer shall measure a liability or an equity instrument related to the
replacement of an acquiree’s share-based payment awards with share-based
payment awards of the acquirer in accordance with the method in [ASC] Topic
718 [Compensation—Stock Compensation]. [ASC] Topic [805] refers to the
result of that method as the fair-value-based measure of the award. [ASC]
paragraphs 805-30-30-9 through 30-13 and 805-30-55-6 through 55-13 provide
additional guidance.
7.177 Liabilities or equity instruments issued by an acquirer to replace share-based
payment awards of an acquiree are measured in accordance with ASC Topic 718. The
attribution of the fair-value-based measure of replacement awards to consideration
transferred and/or postcombination vesting is based on a number of factors, including the
vesting status of the awards and whether the acquirer is required to replace the acquiree
awards. See the discussion of Acquirer Share-Based Payment Awards Exchanged for
Awards Held by the Grantees of the Acquiree in Section 11.
Assets Held for Sale
7.178 An acquirer is required to measure long-lived assets (or a disposal group),
including intangible assets, that are classified as held for sale at the acquisition date in
accordance with ASC Subtopic 360-10. ASC Subtopic 360-10 requires that such assets
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237
7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
be measured at fair value less cost to sell. ASC paragraphs 805-20-30-22, 360-10-35-38
and 35-43
7.179 ASC Topic 805 and ASC Subtopic 820-10 exclude costs to sell in the measurement
of fair value. However, ASC Subtopic 360-10 requires that assets classified as held for
sale be measured at fair value less costs to sell. This inconsistency would have resulted in
the recognition of a loss in the postcombination financial statements of the combined
entity immediately following the acquisition, as an acquirer would have been required to
remeasure the assets held for sale at fair value less costs to sell immediately following an
acquisition. To deal with this inconsistency and avoid the recognition of a loss in the
postcombination financial statements of the combined entity immediately following an
acquisition, ASC Topic 805 provides for an exception to its fair value measurement
principle for assets held for sale. Assets (or a disposal group) that are classified as held
for sale at the acquisition date in accordance with ASC Subtopic 360-10 are measured at
fair value less costs to sell. ASC paragraph 805-20-30-22
7.180 The FASB indicated that the measurement exception provided in ASC Topic 805 is
only an interim step, pending elimination of this inconsistency by amending ASC
Subtopic 360-10 to exclude costs to sell from the measurement of fair value (or carrying
amount) of assets held for sale. Statement 141(R), par. B307
1 ASU 2014-09, Revenue from Contracts with Customers, changes the accounting for revenue from
contracts with customers. The effective dates for ASU 2014-09 have been updated by ASU 2015-14,
Deferral of the Effective Date, and ASU 2020-05, Effective Dates for Certain Entities. The ASU is
effective for public business entities and not-for-profit entities that are conduit bond obligors for annual
periods commencing on or after December 16, 2017. For all other entities (nonpublic entities) that have not
yet issued financial statements or made financial statements available for issuance as of June 3, 2020, the
amendments in this ASU are effective for annual periods in fiscal years beginning after December 15,
2019, and interim periods in fiscal years beginning after December 15, 2020. All other entities may apply
ASU 2014-09 earlier for annual and interim periods in fiscal years beginning after December 15, 2016. All
other entities also may apply ASU 2014-09 earlier as of an annual period in fiscal years beginning after
December 15, 2016, and interim periods in fiscal years beginning one year after the annual period in which
the entity first applies ASU 2014-09.
2 ASU 2016-02, Leases, changes certain aspects of accounting for leases acquired in a business
combination. The ASU is effective for public business entities, certain not-for-profit entities, and certain
employee benefit plans for annual and interim periods in fiscal years beginning after December 15, 2018.
For not-for-profit entities that have issued or are conduit bond obligors for securities that are traded, listed,
or quoted on an exchange or an over-the-counter market that have not yet issued financial statements or
made financial statements available for issuance as of June 3, 2020, it is effective for annual and interim
periods in fiscal years beginning after December 15, 2019. For all other entities, the ASU is effective for
annual periods in fiscal years beginning after December 15, 2021, and interim periods in fiscal years
beginning after December 15, 2022. Early adoption is permitted. See discussion in Section 11 of KPMG
Handbook, Leases.
3 ASU 2016-02, Leases, changes certain aspects of accounting for leases acquired in a business
combination. The ASU is effective for public business entities, certain not-for-profit entities, and certain
employee benefit plans for annual and interim periods in fiscal years beginning after December 15, 2018.
For not-for-profit entities that have issued or are conduit bond obligors for securities that are traded, listed,
or quoted on an exchange or an over-the-counter market that have not yet issued financial statements or
made financial statements available for issuance as of June 3, 2020, it is effective for annual and interim
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238
7. Recognizing and Measuring the Identifiable Assets Acquired,
the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree
periods in fiscal years beginning after December 15, 2019. For all other entities, the ASU is effective for
annual periods in fiscal years beginning after December 15, 2021, and interim periods in fiscal years
beginning after December 15, 2022. Early adoption is permitted. See discussion in Section 11 of KPMG
Handbook, Leases.
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Section 8 - Recognizing and Measuring
Goodwill or a Gain from a Bargain
Purchase
Detailed Contents
Recognizing and Measuring Goodwill
Nature of Goodwill
Overpayments
Bargain Purchase
Example 8.1: A Business Combination in Which the Consideration Transferred
for Less Than 100% of the Equity Interests in the Acquiree Is Less Than the Fair
Value Received
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8. Recognizing and Measuring Goodwill or a Gain from a Bargain Purchase
RECOGNIZING AND MEASURING GOODWILL
8.000 Under ASC Topic 805, Business Combinations, goodwill (or, in some instances a
gain on a bargain purchase) is recognized at the acquisition date, and is measured as a
residual. Goodwill previously recorded by an acquiree is not recorded as a separate asset
by the acquirer. ASC paragraphs 805-30-25-1 and 30-1 discuss the components of the
measurement of goodwill.
ASC Paragraph 805-30-30-1
The acquirer shall recognize goodwill as of the acquisition date, measured as the
excess of (a) over (b) below:
a. The aggregate of the following:
1. The consideration transferred measured in accordance with [ASC
Section 805-30-30], which generally requires acquisition-date fair value
(see [ASC] paragraph 805-30-30-7)
2. The fair value of any noncontrolling interest in the acquiree
3. In a business combination achieved in stages, the acquisition-date fair
value of the acquirer’s previously held equity interest in the acquiree.
b. The net of the acquisition-date amounts of the identifiable assets acquired
and the liabilities assumed measured in accordance with [ASC Topic 805].
8.001 Guidance about recognition and measurement of the various components of the
goodwill measurement (or the measurement of a gain from a bargain purchase) is
included in the following Sections of this book:
(a) The consideration transferred
Sections 6 and 18
(b) Noncontrolling interest in the acquiree
Sections 7 and 19
(c) For a business combination achieved in stages, the
Sections 9 and 20
acquisition-date fair value of the acquirer’s previously held
equity interest in the acquiree
(d) The net of the acquisition-date amounts of the identifiable
assets acquired and the liabilities assumed measured in
accordance with ASC Topic 805
Sections 7 and 17
8.002 A gain on a bargain purchase is recognized in earnings at the acquisition date (see
discussion below). Guidance on the accounting for goodwill subsequent to an acquisition
is included in Section 22 and KPMG Handbook, Impairment of Nonfinancial Assets.
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8. Recognizing and Measuring Goodwill or a Gain from a Bargain Purchase
NATURE OF GOODWILL
ASC Master Glossary: Goodwill
An asset representing the future economic benefits arising from other assets
acquired in a business combination or an acquisition by a not-for-profit entity that
are not individually identified and separately recognized. For ease of reference,
this term also includes the immediate charge recognized by not-for-profit entities
in accordance with paragraph 958-805-25-29.
8.003 Goodwill is an asset representing future economic benefits not attributable to other
identifiable assets. This definition is consistent with the objective of not subsuming into
goodwill amounts that should be separately recognized in a business combination. Thus,
in applying the acquisition method, because goodwill is measured as a residual amount, it
is important that all components of goodwill measurement (or the measurement of a gain
from a bargain purchase) be recognized and measured based on the recognition and
measurement principles (including the exceptions to such principles) of ASC Subtopic
805-30. For example, the failure of an acquirer to recognize and measure all identifiable
assets acquired and liabilities assumed, such as technology-based intangible assets that
were owned by the acquiree but not recognized in the acquiree’s financial statements as
of the acquisition date, would result in a misstatement of both the identifiable net assets
acquired and an equal and offsetting misstatement of goodwill at the acquisition date.
Likewise, following the acquisition, subsuming the identifiable intangible asset into
goodwill could result in misstatements of amortization expense or impairment charges or
both.
OVERPAYMENTS
8.004 While excess consideration transferred over the identifiable assets acquired and
liabilities assumed could represent an overpayment for the acquirer’s interest in the
acquiree, the acquirer does not recognize a loss on a business combination at the
acquisition date. The FASB concluded that in practice it is not possible to identify and
reliably measure an overpayment at the acquisition date. Overpayments are thus
subsumed into goodwill and addressed through subsequent impairment testing of
goodwill. (Statement 141(R), par. B382) See discussion of Goodwill and Other
Intangible Assets in Section 22 and KPMG Handbook, Impairment of Nonfinancial
Assets.
BARGAIN PURCHASE
ASC Paragraph 805-30-25-2
Occasionally, an acquirer will make a bargain purchase, which is a business
combination in which the amount in [ASC] paragraph 805-30-30-1(b) exceeds the
aggregate of the amounts specified in [ASC paragraph 805-30-30-1(a)]. If that
excess remains after applying the requirements in [ASC] paragraph 805-30-25-4,
the acquirer shall recognize the resulting gain in earnings on the acquisition date.
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8. Recognizing and Measuring Goodwill or a Gain from a Bargain Purchase
The gain shall be attributed to the acquirer. Example 1 (see [ASC] paragraph 805-
30-55-14) provides an illustration of this guidance.
ASC Paragraph 805-30-25-3
A bargain purchase might happen, for example, in a business combination that is
a forced sale in which the seller is acting under compulsion. However, the
recognition or measurement exceptions for particular items identified in
paragraphs 805-20-25-16, and 805-20-30-10 also may result in recognizing a gain
(or change the amount of a recognized gain) on a bargain purchase.
ASC Paragraph 805-30-25-4
Before recognizing a gain on a bargain purchase, the acquirer shall reassess
whether it has correctly identified all of the assets acquired and all of the
liabilities assumed and shall recognize any additional assets or liabilities that are
identified in that review. See [ASC] paragraphs 805-30-30-4 through 30-6 for
guidance on the review of measurement procedures in connection with a
reassessment required by this paragraph.
ASC Paragraph 805-30-30-5
… As part of that required reassessment, the acquirer shall then review the
procedures used to measure the amounts [ASC Topic 805] requires to be
recognized at the acquisition date for all of the following:
a. The identifiable assets acquired and liabilities assumed
b. The noncontrolling interest in the acquiree, if any
c. For a business combination achieved in stages, the acquirer’s previously
held equity interest in the acquiree
d. The consideration transferred.
ASC Paragraph 805-30-30-6
The objective of the review is to ensure that the measurements appropriately
reflect consideration of all available information as of the acquisition date.
8.005 Bargain purchases occur if the recognized amounts of the identifiable net assets
exceed the sum of consideration transferred, noncontrolling interests in the acquiree, and
the fair value of any previously held equity interests in the acquiree, in accordance with
ASC paragraph 805-30-30-1(b) The measurement components of the gain on a bargain
purchase are the same as the measurement components of goodwill. Because the
components in the computation are measured at fair value (subject to exceptions for
certain of the identifiable net assets), the FASB concluded that a bargain purchase
represents an economic gain that should be immediately recognized by the acquirer in
earnings.
8.006 Because an owner generally will not knowingly or willingly sell assets or
businesses at prices below their fair values, this situation is expected to occur
infrequently. Examples of transactions that could result in a bargain purchase are as
follows:
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8. Recognizing and Measuring Goodwill or a Gain from a Bargain Purchase
• When the acquiree is under a forced liquidation or distress sale. However,
evidence of a forced or distressed sale is not required for a gain on a bargain
purchase to be recognized.
• When the acquirer and acquiree previously entered into a purchase option for
the set that does not meet the definition of a derivative and the fair value of
the set when the option is exercised exceeds the sum of the strike price and the
premium paid for the option.
• When the acquiree needs to dispose of the business by a specified date and
does not have sufficient time to market the business to several potential
buyers. Similarly, if the acquiree is forced to sell the business at a less than
optimal time such as during an economic downturn to meet liquidity needs.
• When the measurement requirements of ASC Topic 805 which require, in
certain instances, measurement of the identifiable assets acquired and
liabilities assumed at amounts other than fair value (see Section 7).
8.007 Nonetheless, to address concerns over the potential inappropriate recognition of
gains from bargain purchases, the FASB included the requirement in ASC paragraphs
805-30-25-4 and 30-5 through 30-6 that the acquirer, before recognizing a gain on a
bargain purchase, reassess whether it has correctly identified all of the assets acquired,
the liabilities assumed, any noncontrolling interest in the acquiree, any previously held
equity interest in the acquiree, and the consideration transferred. Following that
reassessment, the acquirer must review the procedures used to measure the following
amounts required to be recognized at the acquisition date to ensure that the measurements
reflect consideration of all available information as of the acquisition date:
• The identifiable assets acquired and liabilities assumed;
• Any noncontrolling interest in the acquiree;
• For a business combination achieved in stages, the acquirer’s previously held
equity interest in the acquiree; and
• The consideration transferred.
Although not specifically mentioned in ASC paragraphs 805-30-25-4 and 30-5 through
30-6, we believe that the reassessment process that an acquirer is required to go through
before recognizing a gain on a bargain purchase should also include a review of the
process used to identify amounts that are not part of what the acquirer and acquiree
exchanged in the business combination. For example, a business combination may result
in the effective settlement of a preexisting relationship between the acquirer and the
acquiree (such as a supply agreement or an operating lease arrangement), may include
transactions that compensates employees or former owners of an acquiree for future
services, or may include transactions that reimburse the acquiree or its former owners for
paying the acquirer’s acquisition-related costs. Such transactions are not part of the
business combination transaction, and should therefore be accounted for as separate
transactions. Accounting for such arrangements as separate transactions, rather than as
part of the acquisition, affects the computation of goodwill or the gain from a bargain
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8. Recognizing and Measuring Goodwill or a Gain from a Bargain Purchase
purchase that arises from the business combination. See discussion of Determining What
is Part of the Business Combination Transaction in Section 11.
8.008 Any remaining gain from a bargain purchase after completing the reassessment is
recognized as a gain by the acquirer at the acquisition date. We believe all of the gain
should be attributed to the acquirer and no gain should be attributed to the noncontrolling
interest, if any. ASC paragraph 220-20-45-1 should be considered in determining the
classification in the income statement of any recognized gain from a bargain purchase.
ASC paragraph 805-30-50-1(f) requires disclosure of the amount of any recognized gain
from a bargain purchase, the line items in the income statement in which the gain is
recognized, and a description of the reasons why the transaction resulted in a gain.
8.009 Example 8.1 illustrates the procedures an acquirer follows before recognizing a
gain on a bargain purchase. This example is adapted from Example 1 appearing in ASC
paragraphs 805-30-55-14 through 55-16.
Example 8.1: A Business Combination in Which the Consideration
Transferred for Less Than 100% of the Equity Interests in the Acquiree Is
Less Than the Fair Value Received
On January 1, 20X5, AC acquires 80% of the equity interests of TC, a private entity, in
exchange for cash of $150. Because the former owners of TC needed to dispose of their
investments in TC by a specified date, they lacked sufficient time to market TC to
multiple potential buyers. AC initially measures the identifiable assets acquired and the
liabilities assumed as of the acquisition date in accordance with the requirements of ASC
Topic 805. AC measures the identifiable assets at $250, and the liabilities assumed at
$50. AC engages an independent consultant who determines that the fair value of the
20% noncontrolling interest in TC is $42. AC also performs a review and determines that
the business combination did not include any transactions that should be accounted for
separately from the business combination. The amount of TC’s identifiable net assets
($200, calculated as $250 - $50) exceeds the fair value of the consideration transferred
plus the fair value of the noncontrolling interest in TC, resulting in an initial indication of
a gain on a bargain purchase. Therefore, AC reviews the procedures it used to identify
and measure the assets acquired and liabilities assumed, to measure the fair value of both
the noncontrolling interest in TC and the consideration transferred, and the process it
used to identify transactions that were not part of the business combination. Following
that review, AC concludes that the procedures followed and the resulting measurements
were appropriate. AC measures the gain on its purchase of the 80% interest as follows:
Identifiable net assets acquired ($250 - $50)
Less:
Fair value of the consideration transferred for AC 80% interest in TC
Fair value of the noncontrolling interest in TC
Gain on bargain purchase of 80% interest
$ 200
150
42
192
8
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8. Recognizing and Measuring Goodwill or a Gain from a Bargain Purchase
AC would record its acquisition of TC in its consolidated financial statements as follows:
Identifiable assets acquired
250
Debit
Credit
Cash
Liabilities assumed
Gain on a bargain purchase
Equity—noncontrolling interest in TC
ASC paragraphs 805-30-55-14 through 55-16
150
50
8
42
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Section 9 - Additional Guidance for
Applying the Acquisition Method to
Particular Types of Business
Combinations
Detailed Contents
Business Combinations Achieved in Stages (Step Acquisitions)
Example 9.1: Step Acquisition
Business Combinations Achieved Without the Transfer of Consideration
Measurement of Goodwill in a Business Combination Achieved without the Transfer
of Consideration
A Business Combination Resulting from the Reacquisition by an Acquiree of Its Own
Shares
Example 9.2: Control Obtained Through the Reacquisition of Shares by an
Acquiree
A Business Combination Achieved Through Lapse of Minority Approval or Veto
Rights
Example 9.3: Control Obtained on Lapse of Minority Veto Rights
A Business Combination Achieved by Contract Alone
Example 9.4: Physician Practice Management Entity Enters into a Management
Agreement with a Physician Practice
Reverse Acquisitions
Reverse Acquisitions Involving a Shell Company
Measuring the Consideration Transferred
Preparation and Presentation of Consolidated Financial Statements
Example 9.5: Financial Statement Presentation
Example 9.6: Precombination Shareholdings of the Acquirer
Example 9.7: Presentation of Share-Based Payment Information for Periods Prior
to the Acquisition for a Reverse Acquisition
Noncontrolling Interest in a Reverse Acquisition
Earnings per Share
Example 9.8: Reverse Acquisition
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9. Additional Guidance for Applying the Acquisition Method to
Particular Types of Business Combinations
BUSINESS COMBINATIONS ACHIEVED IN STAGES (STEP
ACQUISITIONS)
ASC Paragraph 805-10-25-9
An acquirer sometimes obtains control of an acquiree in which it held an equity
interest immediately before the acquisition date. For example, on December 31,
20X1, Entity A holds a 35 percent noncontrolling equity interest in Entity B. On
that date, Entity A purchases an additional 40 percent interest in Entity B, which
gives it control of Entity B. [ASC Topic 805] refers to such a transaction as a
business combination achieved in stages, sometimes also referred to as a step
acquisition.
ASC Paragraph 805-10-25-10
In a business combination achieved in stages, the acquirer shall remeasure its
previously held equity interest in the acquiree at its acquisition-date fair value and
recognize the resulting gain or loss, if any, in earnings. In prior reporting periods,
with respect to its previously held equity method investment, the acquirer may
have recognized amounts in other comprehensive income in accordance with
paragraph 323-10-35-18. If so, the amount that was recognized in other
comprehensive income shall be reclassified and included in the calculation of gain
or loss as of the acquisition date. If the business combination achieved in stages
relates to a previously held equity method investment that is a foreign entity, the
amount of accumulated other comprehensive income that is reclassified and
included in the calculation of gain or loss shall include any foreign currency
translation adjustment related to that previously held investment. For guidance on
derecognizing foreign currency translation adjustments recorded in accumulated
other comprehensive income, see Section 830-30-40.
9.000 A business combination occurs on the date the acquirer obtains control of the
acquiree (i.e., the acquisition date). In a business combination achieved in stages, this is
the date on which the acquirer purchases an additional equity interest and gains control of
the acquiree. At that date, the acquirer applies the acquisition method to account for the
combination. The acquirer remeasures its previously held equity interest in the acquiree
at its acquisition-date fair value, and recognizes the resulting gain or loss in earnings
(including changes in value that were previously recognized in accumulated other
comprehensive income). Additionally, the consideration transferred is measured; the
identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the
acquiree are recognized and measured; goodwill or, in some cases, a gain from a bargain
purchase, is recognized and measured, and the accounting acquirer consolidates the
acquiree. See the discussion of The Acquisition Method in Section 3. Refer to Appendix
4-1 in KPMG Handbook, Guide to Accounting for Foreign Currency for discussion of
how to account for foreign currency translation adjustments in business combinations of
foreign equity method investments achieved in stages.
9.001 The following example illustrates the accounting for a step acquisition.
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9. Additional Guidance for Applying the Acquisition Method to
Particular Types of Business Combinations
Example 9.1: Step Acquisition
On December 31, 20X1 ABC Corp. acquires 30% of the outstanding shares of DEF
Corp. for $1,000 cash. The fair value of the identifiable net assets of DEF is $2,500.
DEF has a breakeven net income and other comprehensive income of $100 for the year
ended December 31, 20X2.
On December 31, 20X2, ABC acquires an additional 50% of the outstanding shares of
DEF for $2,000 cash. At that date, the fair value of the identifiable net assets of DEF is
$3,000. ABC determines that the acquisition-date fair value of its original investment
and the noncontrolling interest in DEF at December 31, 20X2 is $1,050 and $700,
respectively. The determination of the fair value of ABC’s original investment does not
reflect consideration of a control premium (i.e., control is associated only with ABC’s
acquisition of an additional 50% interest on December 31, 20X2).
ABC accounts for its investment in DEF during 20X2 by the equity method, and
recognizes $30 (30% × $100) in other comprehensive income, and amortization expense
of $20 related to the fair value adjustments recognized as of December 31, 20X1.
As a result of the acquisition of an additional 50% interest in DEF on December 31,
20X2, ABC obtains control of DEF. Thus, a business combination occurs as of that date
and ABC accounts for the acquisition of DEF by the acquisition method. ABC
determines the goodwill resulting from the acquisition and the gain on its previously
held interest in DEF at the acquisition date as follows:
Goodwill:
Fair value of consideration transferred
Fair value of the noncontrolling interest
Fair value of ABC’s previously held equity interest
Subtotal (a)
Less: Identifiable assets acquired net of liabilities assumed
measured under ASC Topic 805 (b)
Goodwill (a-b)
Gain on previously held equity interest in DEF:
Fair value at December 31, 20X2 (c)
Less basis of ABC’s investment:
Investment at December 31, 20X1
ABC’s equity in DEF’s earnings for 20X2, including
amortization of fair value adjustments
ABC’s share of DEF’s other comprehensive income for
20X2 ($100 × 30%)
ABC’s basis of the previously held equity interest in
DEF before the acquisition of the additional 50%
equity interest (d)
$ 2,000
700
1,050
$ 3,750
3,000
750
$
$ 1,050
1,000
(20)
30
$ 1,010
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9. Additional Guidance for Applying the Acquisition Method to
Particular Types of Business Combinations
Excess of fair value over ABC’s basis in DEF (e)
(equal to (c)-(d))
Recognize AOCI in earnings (f)
Gain on previously held equity interest in DEF recognized in
earnings (e + f)
$
40
30
70
ABC records the following to reflect the gain on its previously held equity interest in
DEF and its acquisition of DEF as of December 31, 20X2:
Identifiable net assets of DEF
Goodwill
AOCI
Cash
Investment in DEF
Noncontrolling interest in DEF
Gain on previously held equity interest in DEF
Debit
Credit
3,000
750
30
2,000
1,010
700
70
9.002 We believe this guidance on business combinations achieved in stages would apply
to transactions involving a previously held interest in an entity that is both a business and
in-substance real estate such as a group of income-producing properties. In such a
transaction, sale of the assets has not occurred (although the accounting for an acquisition
achieved in stages treats the previously held interest as having been disposed and then
reacquired) and therefore ASC Subtopic 360-20 (or ASC Subtopic 610-20 once that
guidance is effective) would not apply. Additionally, the guidance in ASC Subtopic 810-
10 addresses the accounting for a decrease in ownership interest, which also does not
apply. As a consequence, the guidance in ASC paragraph 805-10-25-10 would be
applicable and the previously held interest would be remeasured to fair value with a gain
or loss recognized in income in the period the business combination occurs. However, a
step acquisition of in-substance nonfinancial assets is not a business combination and
therefore outside the scope of ASC paragraph 805-10-25-10.
BUSINESS COMBINATIONS ACHIEVED WITHOUT THE
TRANSFER OF CONSIDERATION
ASC Paragraph 805-10-25-11
An acquirer sometimes obtains control of an acquiree without transferring
consideration. The acquisition method of accounting for a business combination
applies to those combinations. Such circumstances include any of the following:
a. The acquiree repurchases a sufficient number of its own shares for an
existing investor (the acquirer) to obtain control.
b. Minority veto rights lapse that previously kept the acquirer from controlling
an acquiree in which the acquirer held the majority voting interest.
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9. Additional Guidance for Applying the Acquisition Method to
Particular Types of Business Combinations
c. The acquirer and acquiree agree to combine their businesses by contract
alone. The acquirer transfers no consideration in exchange for control of an
acquiree and holds no equity interests in the acquiree, either on the acquisition
date or previously. Examples of business combinations achieved by contract
alone include bringing two businesses together in a stapling arrangement or
forming a dual listed corporation.
9.003 A business combination occurs when an acquirer obtains control of one or more
businesses. When an entity obtains control of a business, even without the transfer of
consideration, a business combination has occurred and is within the scope of ASC Topic
805, Business Combinations. The acquisition method applies to such transactions, which
requires, among other things, recognizing and measuring the assets acquired, the
liabilities assumed, and any noncontrolling interest in the acquiree. ASC Topic 805
provides special guidance for these types of transactions.
9.004 The application of the acquisition method in each of the situations identified in
ASC paragraph 805-10-25-11 in which an acquiree obtains control of an acquiree without
the transfer of consideration is illustrated below.
MEASUREMENT OF GOODWILL IN A BUSINESS COMBINATION ACHIEVED
WITHOUT THE TRANSFER OF CONSIDERATION
ASC Paragraph 805-30-30-3
To determine the amount of goodwill in a business combination in which no
consideration is transferred, the acquirer shall use the acquisition-date fair value
of the acquirer’s interest in the acquiree determined using a valuation technique in
place of the acquisition-date fair value of the consideration transferred (see [ASC]
paragraph 805-30-30-1(a)(1)). Paragraphs 805-30-55-3 through 55-5 provide
additional guidance on applying the acquisition method to combinations of mutual
entities, including measuring the acquisition-date fair value of the acquiree’s
equity interests using a valuation technique.
ASC Paragraph 805-30-55-2
In a business combination achieved without the transfer of consideration, the
acquirer must substitute the acquisition-date fair value of its interest in the
acquiree for the acquisition-date fair value of the consideration transferred to
measure goodwill or a gain on a bargain purchase (see [ASC] paragraphs 805-30-
30-1 through 30-4). [ASC] Subtopic 820-10 provides guidance on using valuation
techniques to measure fair value.
9.005 The determination of goodwill in a business combination achieved without the
transfer of consideration requires the acquirer to substitute the acquisition-date fair value
of its interest in the acquiree for the consideration transferred. The acquisition-date fair
value of the acquirer’s interest is measured using one or more valuation techniques. The
acquisition-date fair value of the acquirer’s interest in the acquiree should reflect, in our
view, any control premium attributable to the acquirer’s controlling financial interest that
will exist as a result of the acquirer obtaining control of the acquiree. The acquirer uses
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9. Additional Guidance for Applying the Acquisition Method to
Particular Types of Business Combinations
the fair value so determined as the consideration transferred to measure goodwill or a
gain on a bargain purchase. This also requires the acquirer to:
• Adjust the carrying amount of its interest in the acquiree to fair value;
• Recognize in earnings any gain or loss equal to the difference between the
carrying amount of its equity interest in the acquiree before gaining control of
the acquiree and the fair value of its controlling interest in the acquiree as a
result of the transaction; and
• To otherwise apply the acquisition method in accounting for the business
combination.
A BUSINESS COMBINATION RESULTING FROM THE REACQUISITION BY AN
ACQUIREE OF ITS OWN SHARES
9.006 If an investee (acquiree) buys back enough of its own shares such that an existing
shareholder (acquirer) obtains control of the acquiree, a business combination has
occurred and the acquirer would apply the acquisition method to account for the
transaction.
Example 9.2: Control Obtained Through the Reacquisition of Shares by an
Acquiree
ABC Corp. owns 45% of DEF Corp. DEF repurchases a number of its shares such that
ABC’s ownership percentage increases to 55%. The repurchase transaction results in
ABC obtaining control of DEF and, therefore, is a business combination under ASC
Topic 805. ABC is the acquirer of DEF, and accounts for the business combination by the
acquisition method. As of the acquisition date (i.e., the date ABC obtains control), ABC:
(1) Remeasures its previously held interest in DEF (45%) at its acquisition-date
fair value, and recognizes in earnings any gain or loss equal to the difference
between the carrying amount of its equity interest in DEF before gaining
control and the fair value of its controlling interest in DEF as a result of the
transaction.
(2) Recognizes and measures the identifiable assets acquired, the liabilities
assumed, and the noncontrolling interest in DEF based on the recognition and
measurement principles of ASC Topic 805.
(3) Recognizes and measures goodwill or a gain from a bargain purchase, using
the fair value of its controlling interest in DEF as a result of the transaction as
a substitute for the consideration transferred.
See Section 3 for a discussion of The Acquisition Method.
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9. Additional Guidance for Applying the Acquisition Method to
Particular Types of Business Combinations
A BUSINESS COMBINATION ACHIEVED THROUGH LAPSE OF MINORITY
APPROVAL OR VETO RIGHTS
9.007 An entity (investor) may own a majority interest in another entity (investee), but
not consolidate that entity, because the noncontrolling interests in the investee have
substantive participating rights that overcome the usual presumption that the investor
with a majority voting interest should consolidate the investee. See ASC paragraphs 810-
10-25-2 through 25-14 and ASC Section 810-20-25. In such situations, if the substantive
participating rights held by the noncontrolling interests expire and the investor holding
the majority voting interest gains control of the investee, the investor has acquired the
investee in a business combination, and therefore applies the acquisition method to
account for the transaction.
Example 9.3: Control Obtained on Lapse of Minority Veto Rights
ABC Corp. owns 55% of DEF Corp. but does not consolidate DEF because of
substantive participating rights held by the minority shareholders (see ASC paragraphs
810-10-25-2 through 25-14). On September 30, 20X9, the veto rights expire. The lapse of
minority veto rights results in ABC obtaining control of DEF and, therefore, this event
meets the definition of a business combination under ASC Topic 805. ABC is the
acquirer of DEF, and accounts for the business combination by the acquisition method.
As of the acquisition date (i.e., September 30, 20X9), the carrying amount of ABC’s 55%
interest in DEF is $42 million. ABC also determines, using one or more valuation
techniques, that the acquisition-date fair value of DEF’s identifiable assets and liabilities
is $90 million (determined in accordance with the recognition and measurement
principles of ASC Topic 805), the acquisition-date fair value of ABC’s 55% interest in
DEF (including a control premium) is $60 million, and the acquisition-date fair value of
the 45% noncontrolling interest after the transaction is $45 million.
In applying the acquisition method to this transaction, ABC:
(1) Remeasures its previously held interest in DEF at its acquisition-date fair
value ($60 million), adjusts the carrying amount of its interest in DEF to the
fair value so determined, and recognizes in earnings the resulting gain of $18
million ($60 million fair value of its controlling interest as a result of the
transaction less the $42 million historical carrying amount of ABC’s equity
interest in DEF).
(2) Recognizes and measures the identifiable assets acquired and the liabilities
assumed in accordance with the recognition and measurement principles of
ASC Topic 805 ($90 million), and the noncontrolling interest in DEF at its
acquisition-date fair value ($45 million).
(3) Recognizes goodwill of $15 million ($60 fair value of ABC’s controlling
interest in DEF used as a substitute for the consideration transferred plus the
$45 million acquisition-date fair value of the noncontrolling interest in DEF,
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less the $90 million fair value of DEF’s identifiable assets and liabilities).
ABC’s entries to record the acquisition of DEF are:
Investment in DEF
Gain on previously held investment in DEF
Identifiable net assets
Goodwill
Investment in DEF
Noncontrolling interest in DEF
See discussion of The Acquisition Method in Section 3.
Debit
Credit
18 million
90 million
15 million
18 million
60 million
45 million
A BUSINESS COMBINATION ACHIEVED BY CONTRACT ALONE
ASC Paragraph 805-10-25-12
In a business combination achieved by contract alone, the acquirer shall attribute
to the equity holders of the acquiree the amount of the acquiree’s net assets
recognized in accordance with the requirements of [ASC] Topic [805]. In other
words, the equity interests in the acquiree held by parties other than the acquirer
are a noncontrolling interest in the acquirer’s postcombination financial
statements even if the result is that all of the equity interests in the acquiree are
attributed to the noncontrolling interest.
9.008 Business combinations achieved by contract alone are within the scope of ASC
Topic 805 and are accounted for by the acquisition method. Thus, the acquirer recognizes
the assets acquired and liabilities assumed in accordance with the recognition and
measurement requirements of ASC Topic 805. This applies to such transactions even if
the acquirer did not previously hold or acquire any equity interest in the acquiree. Equity
interests held by parties other than the acquirer (i.e., the party that obtains control by
contract) are noncontrolling interests and are presented as such in the acquirer’s
postcombination financial statements.
9.009 Business combinations achieved by contract alone often result in the formation of a
variable interest entity. In such situations, the primary beneficiary of the variable interest
entity is always the acquirer. See the discussion below and the discussion of Variable
Interest Entities in Section 4.
9.010 Paragraph B78 of Statement 141(R) cites as an example of a business combination
achieved by contract alone a transaction in which a physician practice management entity
executes a management agreement with a physician practice, and notes that the EITF
reached a consensus that these transactions should be accounted for as business
combinations. ASC paragraphs 810-10-15-19 through 15-22, 25-61 through 25-81, and
55-206 through 55-209
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Example 9.4: Physician Practice Management Entity Enters into a
Management Agreement with a Physician Practice
Q. Should the acquisition method be applied in a transaction in which a physician
practice management entity (PPM) executes a management agreement with a physician
practice (assume the physician practice is a business)?
A. Many of the arrangements between a physician practice and a PPM arise when the
PPM seeks to acquire the physician practice. Legal or business reasons often preclude the
PPM from acquiring the physician practice’s outstanding equity instruments. As an
alternative, the PPM often will acquire some or all of the net assets of the physician
practice, assume some or all of its contractual rights and responsibilities, and execute a
long-term management agreement to operate the physician practice with its owners
(typically the physicians) receiving consideration in exchange. ASC paragraphs 810-10-
25-61 through 25-81 provide guidance for determining when a controlling financial
interest in a physician practice through a contractual management arrangement with a
PPM is established.
A PPM can have a controlling financial interest, but not own the majority of the
outstanding voting equity instruments of the physician practice. As a result, many PPMs
will be variable interest entities.
If a PPM establishes a controlling financial interest in a physician practice through a
contractual management arrangement, and the physician practice is not a variable interest
entity, then the PPM should apply the acquisition method in accordance with ASC Topic
805. However, if the physician practice is a variable interest entity, the primary
beneficiary is the acquirer and, accordingly, the primary beneficiary (which could be the
PPM) would apply the acquisition method. See the discussion of Variable Interest
Entities in Section 4.
9.011 While ASC paragraphs 810-10-25-61 through 25-81 relate to entities that operate
in the health care industry, its guidance for establishing a controlling financial interest
applies to similar arrangements in other industries. For example, this guidance might
apply to research and development arrangements, franchise arrangements, hotel
management contracts, and service corporations for real estate investment trusts. These
arrangements may involve the transfer of significant rights from the legal owners of an
entity to another entity via a management arrangement or similar contract. If an entity
establishes a controlling financial interest in another entity (acquiree) that is a business as
a result of entering into a management arrangement, the entity should first assess whether
the acquiree is a variable interest entity. If the acquiree is a variable interest entity, the
primary beneficiary of the acquiree is the acquirer, and should apply the acquisition
method and consolidate the variable interest entity. If the acquiree is not a variable
interest entity, the entity that established the controlling financial interest in the acquiree
is the acquirer, and should apply the acquisition method and consolidate the entity. See
Section 4 for a discussion of Variable Interest Entities.
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REVERSE ACQUISITIONS
ASC Master Glossary: Reverse Acquisition
An acquisition in which the entity that issues securities (the legal acquirer) is
identified as the acquiree for accounting purposes based on the guidance in [ASC]
paragraphs 805-10-55-11 through 55-15. The entity whose equity interests are
acquired (the legal acquiree) must be the acquirer for accounting purposes for the
transaction to be considered a reverse acquisition.
ASC Paragraph 805-40-05-2 (Emphasis added)
As one example of a reverse acquisition, a private operating entity may want to
become a public entity but not want to register its equity shares. To become a
public entity, the private entity will arrange for a public entity to acquire its equity
interests in exchange for the equity interests of the public entity. In this situation,
the public entity is the legal acquirer because it issued its equity interests, and the
private entity is the legal acquiree because its equity interests were acquired.
However, application of the guidance in [ASC] paragraphs 805-10-55-11 through
55-15 results in identifying:
a. The public entity as the acquiree for accounting purposes (the accounting
acquiree)
b. The private entity as the acquirer for accounting purposes (the accounting
acquirer).
ASC Paragraph 805-40-25-1
For a business combination transaction to be accounted for as a reverse
acquisition, the accounting acquiree must meet the definition of a business. All of
the recognition principles in [ASC] Subtopics 805-10, 805-20, and 805-30,
including the requirement to recognize goodwill, apply to a reverse acquisition.
ASC Paragraph 805-40-30-1
All of the measurement principles applicable to business combinations in [ASC]
Subtopics 805-10, 805-20, and 805-30 apply to a reverse acquisition.
9.012 The example of a reverse acquisition included in ASC Section 805-40-55 is
comprehensive in nature. That example is presented below in its entirety as Example 9.8
in Paragraph 9.019 to illustrate the basic concepts that apply to the accounting for reverse
acquisitions.
9.013 See Example 6.3, Transfer of a Subsidiary to an Acquiree, in Section 6 for an
additional example of a reverse acquisition.
REVERSE ACQUISITIONS INVOLVING A SHELL COMPANY
9.014 The SEC staff has taken the position that a transaction between a private operating
company and a nonoperating public shell company, in which the shell company is the
issuer of securities and the operating company is the acquirer for accounting purposes,
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should be treated for financial reporting purposes as an issuance of securities by the
operating company. These transactions are not business combinations because the shell
company is not a business. The operating company would credit equity for the fair value
of the net monetary assets of the shell company (i.e., no goodwill or intangible assets
would be recognized in this transaction). Costs directly related to this transaction should
be charged to equity only to the extent of cash received, while all costs in excess of cash
received should be charged to expense.
9.014a Whether a public company meets the SEC’s definition of a shell company is a
legal determination that should be performed by the company’s SEC legal counsel.
9.014b In many instances, a reverse acquisition may involve a public company that no
longer has future operating prospects (e.g. a life sciences company whose only drug
candidate fails during clinical trials). The public company may find a merger partner in
the form of a private company that wants to go public. A reverse acquisition may benefit
both parties as it maximizes value for the shareholders of the public company and allows
the private company to become public without incurring the cost and time associated with
an IPO process. Often, the public company does not meet the SEC’s definition of a shell
company because it had significant precombination assets and/or activities.
9.015 Even if a public company does not meet the SEC’s definition of a shell company,
the public company may have little to no assets (other than cash or cash equivalents) or
activities by the time the reverse acquisition is consummated. If the public company's
assets or activities just prior to the reverse acquisition meet the definition of a business,
and the private company is the acquirer for accounting purposes, the transaction
constitutes a business combination. However, if the assets and activities of the public
company are not sufficient to meet the definition of a business, and the private company
is the acquirer for accounting purposes, the accounting acquirer would account for this
transaction as the acquisition of a group of assets.
MEASURING THE CONSIDERATION TRANSFERRED
ASC Paragraph 805-40-30-2
In a reverse acquisition, the accounting acquirer usually issues no consideration
for the acquiree. Instead, the accounting acquiree usually issues its equity shares
to the owners of the accounting acquirer. Accordingly, the acquisition-date fair
value of the consideration transferred by the accounting acquirer for its interest in
the accounting acquiree is based on the number of equity interests the legal
subsidiary would have had to issue to give the owners of the legal parent the same
percentage equity interest in the combined entity that results from the reverse
acquisition. Example 1, Case A (see [ASC] paragraph 805-40-55-8) illustrates
that calculation. The fair value of the number of equity interests calculated in that
way can be used as the fair value of consideration transferred in exchange for the
acquiree.
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PREPARATION AND PRESENTATION OF CONSOLIDATED FINANCIAL
STATEMENTS
ASC Paragraph 805-40-45-1
Consolidated financial statements prepared following a reverse acquisition are
issued under the name of the legal parent (accounting acquiree) but described in
the notes as a continuation of the financial statements of the legal subsidiary
(accounting acquirer), with one adjustment, which is to retroactively adjust the
accounting acquirer’s legal capital to reflect the legal capital of the accounting
acquiree. That adjustment is required to reflect the capital of the legal parent (the
accounting acquiree). Comparative information presented in those consolidated
financial statements also is retroactively adjusted to reflect the legal capital of the
legal parent (accounting acquiree).
ASC Paragraph 805-40-45-2 (Emphasis added)
Because the consolidated financial statements represent the continuation of the
financial statements of the legal subsidiary except for its capital structure, the
consolidated financial statements reflect all of the following:
a. The assets and liabilities of the legal subsidiary (the accounting acquirer)
recognized and measured at their precombination carrying amounts.
b. The assets and liabilities of the legal parent (the accounting acquiree)
recognized and measured in accordance with [ASC] Topic [805] applicable to
business combinations.
c. The retained earnings and other equity balances of the legal subsidiary
(accounting acquirer) before the business combination.
d. The amount recognized as issued equity interests in the consolidated
financial statements determined by adding the issued equity interest of the
legal subsidiary (the accounting acquirer) outstanding immediately before the
business combination to the fair value of the legal parent (accounting
acquiree) determined in accordance with the guidance in [ASC] Topic [805]
applicable to business combinations. However, the equity structure (that is,
the number and type of equity interests issued) reflects the equity structure of
the legal parent (the accounting acquiree), including the equity interests the
legal parent issued to effect the combination. Accordingly, the equity structure
of the legal subsidiary (the accounting acquirer) is restated using the exchange
ratio established in the acquisition agreement to reflect the number of shares
of the legal parent (the accounting acquiree) issued in the reverse acquisition.
e. The noncontrolling interest’s proportionate share of the legal subsidiary’s
(accounting acquirer’s) precombination carrying amounts of retained earnings
and other equity interests as discussed in [ASC] paragraphs 805-40-25-2 and
805-40-30-3 and illustrated in Example 1, Case B (see [ASC] paragraph 805-
40-55-18).
9.016 In a business combination, the acquirer recognizes the assets and liabilities of the
acquiree in accordance with the recognition and measurement principles of ASC Topic
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805. The acquirer includes the acquiree’s results of operations in its postcombination
financial statements from the acquisition date. This guidance also applies to reverse
acquisitions, in which the acquiree (for accounting purposes) is the surviving entity. The
historical financial statements of the acquirer (for accounting purposes) are presented as
the historical financial statements of the combined entity, and the assets and liabilities of
the acquiree (the legal acquirer) are recognized and measured in accordance with the
recognition and measurement principles of ASC Topic 805. Likewise, the results of
operations of the acquired entity (the legal acquirer) are included in the financial
statements of the combined entity only from the date of acquisition, even if the acquired
entity (legal acquirer) is the surviving entity.
9.017 The equity of the acquirer is presented as the equity of the combined entity;
however, the capital share account of the acquirer is adjusted to reflect the par value of
the outstanding shares of the legal acquirer after considering the number of shares issued
in the business combination. The difference between the capital share account of the
acquirer and the capital share account of the legal acquirer (presented as the capital share
account of the combined entity) is recorded as an adjustment to additional paid-in capital
of the combined entity. For periods prior to the business combination, the equity of the
combined entity is the historical equity of the acquirer prior to the merger, retroactively
restated to reflect the number of shares received in the business combination. Retained
earnings of the acquirer are carried forward after the acquisition. Earnings per share for
periods prior to the business combination are restated to reflect the number of equivalent
shares received by the acquirer.
Example 9.5: Financial Statement Presentation
ABC Corp. issues common shares to the shareholders of DEF Corp. in exchange for all
outstanding common shares of DEF. On consummation of the combination, DEF
becomes a wholly owned subsidiary of ABC and the former shareholders of DEF own
60% of the outstanding common shares of ABC.
Because the former shareholders of DEF receive the larger portion of the voting interests
in the combined entity, and assuming there is no evidence pointing to a different
acquiring entity, DEF is the acquirer for accounting purposes.
For purposes of the consolidated financial statements of the surviving entity (ABC),
DEF’s historical financial statements should be presented as the historical financial
statements of the combined entity. The assets and liabilities of ABC should be recognized
and measured in accordance with ASC Topic 805 as of the acquisition date. The results
of operations of ABC are included in the financial statements of the combined entity only
for periods subsequent to the acquisition.
Although the equity of DEF (the acquirer) is presented as the equity of the combined
entity, the capital share account must be adjusted to reflect the outstanding shares of ABC
(the surviving entity). That is, the retained earnings of DEF would be presented as the
retained earnings of the combined entity; the capital share account of the combined entity
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would reflect the par value of ABC’s shares; and the additional paid-in capital account of
DEF would be adjusted for the difference between the capital share account of DEF and
the capital share account of ABC, and that adjusted amount would be presented as
additional paid-in capital of the combined entity.
Example 9.6: Precombination Shareholdings of the Acquirer
Q. How should shares of a legal acquirer that had been held by the accounting acquirer
prior to a reverse acquisition be considered in accounting for the business combination?
A. The transaction should be accounted for as a business combination achieved in stages
(step acquisition). The accounting acquirer would recognize and measure the legal
acquirer’s identifiable assets and liabilities, the previously held interest and
noncontrolling interest at acquisition-date fair value. The accounting acquirer would
recognize a gain or loss for the difference between the carrying amount of the previously
held investment in the legal acquirer and the acquisition-date fair value (see Paragraph
9.005).
Example 9.7: Presentation of Share-Based Payment Information for Periods
Prior to the Acquisition for a Reverse Acquisition
Q. Should the accounting acquirer in a transaction accounted for as a reverse acquisition
retrospectively adjust its share-based payment disclosures for periods prior to the
business combination when the equity of the accounting acquirer has been retrospectively
adjusted to reflect the shares received in the business combination?
A. Yes, in our view it would be appropriate to adjust the share-based payment disclosures
to reflect the impact of the business combination on a basis that is comparable to the
retrospectively adjusted legal capital that is presented in shareholders’ equity.
NONCONTROLLING INTEREST IN A REVERSE ACQUISITION
ASC Paragraph 805-40-25-2
In a reverse acquisition, some of the owners of the legal acquiree (the accounting
acquirer) might not exchange their equity interests for equity interests of the legal
parent (the accounting acquiree). Those owners are treated as a noncontrolling
interest in the consolidated financial statements after the reverse acquisition. That
is because the owners of the legal acquiree that do not exchange their equity
interests for equity interests of the legal acquirer have an interest in only the
results and net assets of the legal acquiree—not in the results and net assets of the
combined entity. Conversely, even though the legal acquirer is the acquiree for
accounting purposes, the owners of the legal acquirer have an interest in the
results and net assets of the combined entity.
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ASC Paragraph 805-40-30-3
The assets and liabilities of the legal acquiree are measured and recognized in the
consolidated financial statements at their precombination carrying amounts (see
[ASC] paragraph 805-40-45-2(a)). Therefore, in a reverse acquisition the
noncontrolling interest reflects the noncontrolling shareholders’ proportionate
interest in the precombination carrying amounts of the legal acquiree’s net assets
even though the noncontrolling interests in other acquisitions are measured at
their fair values at the acquisition date.
9.018 In a reverse acquisition, the combined entity should reflect a noncontrolling interest
when the legal acquirer does not obtain all the ownership interests in the legal acquiree.
This noncontrolling interest is measured based on the proportionate share of the
precombination carrying amounts of the accounting acquirer's (legal acquiree's) net
assets. Other financial instruments that are classified as equity in the legal acquiree’s
financial statements that remain outstanding after a reverse acquisition are also classified
as a noncontrolling interest in the postcombination financial statements of the combined
entity.
EARNINGS PER SHARE
ASC Paragraph 805-40-45-3
As noted in [ASC paragraph 805-40-45-2](d), the equity structure in the
consolidated financial statements following a reverse acquisition reflects the
equity structure of the legal acquirer (the accounting acquiree), including the
equity interests issued by the legal acquirer to effect the business combination.
ASC Paragraph 805-40-45-4
In calculating the weighted-average number of common shares outstanding (the
denominator of the earnings-per-share [EPS] calculation) during the period in
which the reverse acquisition occurs:
a. The number of common shares outstanding from the beginning of that
period to the acquisition date shall be computed on the basis of the weighted-
average number of common shares of the legal acquiree (accounting acquirer)
outstanding during the period multiplied by the exchange ratio established in
the merger agreement.
b. The number of common shares outstanding from the acquisition date to the
end of that period shall be the actual number of common shares of the legal
acquirer (the accounting acquiree) outstanding during that period.
ASC Paragraph 805-40-45-5
The basic EPS for each comparative period before the acquisition date presented
in the consolidated financial statements following a reverse acquisition shall be
calculated by dividing (a) by (b):
a. The income of the legal acquiree attributable to common shareholders in
each of those periods
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b. The legal acquiree’s historical weighted average number of common shares
outstanding multiplied by the exchange ratio established in the acquisition
agreement.
9.018a For further guidance on the calculation and presentation of EPS in a reverse
acquisition, see Section 7.5.20 of KPMG Handbook, Earnings Per Share.
Comprehensive Example
9.019 The following example is included in ASC paragraphs 805-40-55-3 through 55-23.
The example demonstrates the application of the guidance and concepts discussed in
ASC paragraphs 805-40-25-2, 30-2 and 30-3, and 45-1 through 45-5.
Example 9.8: Reverse Acquisition
This example illustrates the accounting for a reverse acquisition in which Entity B, the legal
subsidiary, acquires Entity A, the entity issuing equity instruments and therefore the legal
parent, on September 30, 20X6. This example ignores the accounting for any income tax
effects.
The statements of financial position of Entity A and Entity B immediately before the
business combination are:
Entity A
(Legal Parent,
Accounting
Acquiree)
$
Entity B
(Legal Subsidiary,
Accounting
Acquirer)
$
Current assets
Noncurrent assets
Total assets
Current liabilities
Noncurrent liabilities
Total liabilities
Shareholders’ equity
Retained earnings
Issued equity
100 common shares
60 common shares
Total shareholders’ equity
Total liabilities and
shareholders’ equity
500
1,300
1,800
300
400
700
800
300
—
1,100
1,800
700
3,000
3,700
600
1,100
1,700
1,400
—
600
2,000
3,700
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This example also uses the following information:
(a) On September 30, 20X6, Entity A issues 2.5 shares in exchange for each
common share of Entity B. All of Entity B’s shareholders exchange their shares
in Entity B. Therefore, Entity A issues 150 common shares in exchange for all
60 common shares of Entity B.
(b) The fair value of each common share of Entity B at September 30, 20X6, is $40.
The quoted market price of Entity A’s common shares at that date is $16.
(c) The fair values of Entity A’s identifiable assets and liabilities at September 30,
20X6, are the same as their carrying amounts, except that the fair value of Entity
A’s noncurrent assets at September 30, 20X6, is $1,500.
Calculating the Fair Value of the Consideration Transferred
As a result of the issuance of 150 common shares by Entity A (legal parent, accounting
acquiree), Entity B’s shareholders own 60 percent of the issued shares of the combined
entity (that is, 150 of 250 issued shares). The remaining 40 percent are owned by Entity A’s
shareholders. If the business combination had taken the form of Entity B issuing additional
common shares to Entity A’s shareholders in exchange for their common shares in Entity A,
Entity B would have had to issue 40 shares for the ratio of ownership interest in the
combined entity to be the same. Entity B’s shareholders would then own 60 of the 100
issued shares of Entity B—60 percent of the combined entity. As a result, the fair value of
the consideration effectively transferred by Entity B and the group’s interest in Entity A is
$1,600 (40 shares with a per-share fair value of $40). The fair value of the consideration
effectively transferred should be based on the most reliable measure. In this example, the
quoted market price of Entity A’s shares provides a more reliable basis for measuring the
consideration effectively transferred than the estimated fair value of the shares in Entity B,
and the consideration is measured using the market price of Entity A’s shares—100 shares
with a per-share fair value of $16.
Measuring Goodwill
Goodwill is measured as the excess of the fair value of the consideration effectively
transferred (the group’s interest in Entity A) over the net amount of Entity A’s recognized
identifiable assets and liabilities, as follows:
Consideration effectively transferred
Net recognized values of Entity A’s
identifiable assets and liabilities
Current assets
Noncurrent assets
Current liabilities
Noncurrrent liabilities
Goodwill
$
500
1,500
(300)
(400)
$
1,600
(1,300)
300
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The consolidated statement of financial position immediately after the business combination
is:
Current assets ($700 + $500)
Noncurrent assets ($3,000 + $1,500)
Goodwill
Total assets
Current liabilities ($600 + $300)
Noncurrent liabilities ($1,100 + $400)
Total liabilities
Shareholders’ equity
Retained earnings
Issued equity
250 common shares ($600 + $1,600)
Total shareholders’ equity
Total liabilities and shareholders’ equity
$
1,200
4,500
300
6,000
900
1,500
2,400
1,400
2,200
3,600
6,000
In accordance with ASC paragraphs 805-40-45-2(c) through 45-2(d), the amount recognized
as issued equity interests in the consolidated financial statements ($2,200) is determined by
adding the issued equity of the legal subsidiary immediately before the business
combination ($600) and the fair value of the consideration effectively transferred, measured
in accordance with ASC paragraph 805-40-30-2 ($1,600). However, the equity structure
appearing in the consolidated financial statements (that is, the number and type of equity
interests issued) must reflect the equity structure of the legal parent, including the equity
interests issued by the legal parent to effect the combination.
Earnings per Share
ASC paragraph 805-40-55-16. Entity B’s earnings for the annual period ending December
31, 20X5, was $600, and the consolidated earnings for the annual period ending December
31, 20X6, is $800. There was no change in the number of common shares issued by Entity
B during the annual period ending December 31, 20X5, and during the period from January
1, 20X6, to the date of the reverse acquisition on September 30, 20X6. Earnings per share
for the annual period ended December 31, 20X6, is calculated as follows:
Number of shares deemed to be outstanding for the period from
January 1, 20X6, to the acquisition date (that is, the number of
common shares issued by Entity A (legal parent, accounting acquiree)
in the reverse acquisition)
Number of shares outstanding from the acquisition date to
December 31, 20X6
150
250
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9. Additional Guidance for Applying the Acquisition Method to
Particular Types of Business Combinations
Weighted-average number of common shares outstanding
([150 × 9 ÷ 12] + [250 × 3 ÷ 12])
Earnings per share (800 ÷ 175)
175
4.57
$
Restated EPS for the annual period ending December 31, 20X5, is $4.00 (calculated as the
earnings of Entity B of 600 divided by the 150 common shares Entity A issued in the
reverse acquisition).
Noncontrolling Interest
Assume the same facts as above, except that only 56 of Entity B’s 60 common shares are
exchanged. Because Entity A issues 2.5 shares in exchange for each common share of
Entity B, Entity A issues only 140 (rather than 150) shares. As a result, Entity B’s
shareholders own 58.3 percent of the issued shares of the combined entity (140 of 240
issued shares). The fair value of the consideration transferred for Entity A, the accounting
acquiree, is calculated by assuming that the combination had been effected by Entity B’s
issuing additional common shares to the shareholders of Entity A in exchange for their
common shares in Entity A. That is because Entity B is the accounting acquirer, and ASC
paragraphs 805-30-30-7 and 30-8 require the acquirer to measure the consideration
exchanged for the accounting acquiree. In calculating the number of shares that Entity B
would have had to issue, the noncontrolling interest is ignored. The majority shareholders
own 56 shares of Entity B. For that to represent a 58.3 percent equity interest, Entity B
would have had to issue an additional 40 shares. The majority shareholders would then own
56 of the 96 issued shares of Entity B and, therefore, 58.3 percent of the combined entity.
As a result, the fair value of the consideration transferred for Entity A, the accounting
acquiree, is $1,600 (that is, 40 shares each with a fair value of $40). That is the same
amount as when all 60 of Entity B’s shareholders tender all 60 of its common shares for
exchange. The recognized amount of the group’s interest in Entity A, the accounting
acquiree, does not change if some of Entity B’s shareholders do not participate in the
exchange.
The noncontrolling interest is represented by the 4 shares of the total 60 shares of Entity B
that are not exchanged for shares of Entity A. Therefore, the noncontrolling interest is 6.7
percent. The noncontrolling interest reflects the noncontrolling shareholders’ proportionate
interests in the precombination carrying amounts of the net assets of Entity B, the legal
subsidiary. Therefore, the consolidated statement of financial position is adjusted to show a
noncontrolling interest of 6.7 percent of the precombination carrying amounts of Entity B’s
net assets (that is, $134 or 6.7 percent of $2,000).
The consolidated statement of financial position at September 30, 20X6, reflecting the
noncontrolling interest is as follows:
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9. Additional Guidance for Applying the Acquisition Method to
Particular Types of Business Combinations
Current assets ($700 + $500)
Noncurrent assets ($3,000 + $1,500)
Goodwill
Total assets
Current liabilities ($600 + $300)
Noncurrent liabilities ($1,100 + $400)
Total liabilities
Shareholders’ equity
Retained earnings ($1,400 × 93.3%)
Issued equity
240 common shares ($560 + $1,600)
Noncontrolling interest
Total shareholders’ equity
Total liabilities and shareholders’ equity
$
1,200
4,500
300
6,000
900
1,500
2,400
1,306
2,160
134
3,600
6,000
The noncontrolling interest of $134 has 2 components. The first component is the
reclassification of the noncontrolling interest’s share of the accounting acquirer’s retained
earnings immediately before the acquisition ($1,400 × 6.7% or $93.80). The second
component represents the reclassification of the noncontrolling interest’s share of the
accounting acquirer’s issued equity ($600 × 6.7% or $40.20).
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Section 10 - Measurement Period
Detailed Contents
Definition and Purpose of the Measurement Period
The Measurement Period
Financial Reporting When the Initial Accounting for a Business Combination Is
Incomplete
Reporting of Provisional Amounts
Disclosures
Adjustments to Provisional Amounts During the Measurement Period
Identifying Adjustments to Provisional Amounts
Example 10.1: Use of Hindsight When Measuring the Fair Value of Contingent
Consideration
Example 10.2: Information Becomes Available before and Shortly after the
Measurement Period Ends
Adjustments to Provisional Amounts Are Reported in the Subsequent Period
Other Examples of Measurement Period Adjustments
Incomplete Valuation Information at the Reporting Date
Example 10.3: Appraisal Received during the Measurement Period Identifies
Decrease in Fair Value Occurring after the Acquisition Date
Example 10.4: Pension Plan Valuation Not Completed at the Acquisition Date
Obligation for Defective Products
Example 10.5: New Information on Defective Product Liability Obtained during
the Measurement Period
Loans Acquired in an Acquisition
Example 10.6: New Information on the Fair Value of an Acquired Loan Obtained
during the Measurement Period
Example 10.7: Decrease in Fair Value of Acquired Loan Resulting from an Event
Occurring during the Measurement Period
New Information Obtained on a Contingency Identified Pre-Combination
Example 10.8: Contingency Existed but Additional Information Identified after
the Acquisition Date
After the Measurement Period Ends, the Acquisition Accounting Is Adjusted Only to
Correct Errors
Example 10.9: Error Discovered after the End of the Measurement Period
Adjustments to Provisional Amounts Related to Deferred Tax Assets and Liabilities
During the Measurement Period
Contingent Consideration
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10. Measurement Period
DEFINITION AND PURPOSE OF THE MEASUREMENT PERIOD
THE MEASUREMENT PERIOD
ASC Paragraph 805-10-25-13
If the initial accounting for a business combination is incomplete by the end of the
reporting period in which the combination occurs, the acquirer shall report in its
financial statements provisional amounts for the items for which the accounting is
incomplete. During the measurement period, in accordance with [ASC] paragraph
805-10-25-17, the acquirer shall adjust the provisional amounts recognized at the
acquisition date to reflect new information obtained about facts and circumstances
that existed as of the acquisition date that, if known, would have affected the
measurement of the amounts recognized as of that date.
ASC Paragraph 805-10-25-14
During the measurement period, the acquirer also shall recognize additional assets
or liabilities if new information is obtained about facts and circumstances that
existed as of the acquisition date that, if known, would have resulted in the
recognition of those assets and liabilities as of that date. The measurement period
ends as soon as the acquirer receives the information it was seeking about facts
and circumstances that existed as of the acquisition date or learns that more
information is not obtainable. However, the measurement period shall not exceed
one year from the acquisition date.
ASC Paragraph 805-10-25-15
The measurement period is the period after the acquisition date during which the
acquirer may adjust the provisional amounts recognized for a business
combination. The measurement period provides the acquirer with a reasonable
time to obtain the information necessary to identify and measure any of the
following as of the acquisition date in accordance with the requirements of [ASC]
Topic [805]:
a. The identifiable assets acquired, liabilities assumed, and any noncontrolling
interest in the acquiree (see [ASC] Subtopic 805-20)
b. The consideration transferred for the acquiree (or the other amount used in
measuring goodwill in accordance with [ASC] paragraphs 805-30-30-1
through 30-3)
c. In a business combination achieved in stages, the equity interest in the
acquiree previously held by the acquirer (see [ASC] paragraph 805-30-30-
1(a)(3))
d. The resulting goodwill recognized in accordance with [ASC] paragraph
805-30-30-1 or the gain on a bargain purchase recognized in accordance with
[ASC] paragraph 805-30-25-2.
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10. Measurement Period
10.000 The information necessary to enable an acquirer to complete the identification and
measurement of these items often will be unavailable by the end of the first reporting
period following the acquisition date. For example, appraisals may be required to
determine fair value of plant and equipment acquired, a discovery period might be needed
to identify and value intangible assets acquired, and an actuarial determination may be
required to determine the pension liability (or asset) to be recorded. Additionally, if a
business combination is consummated near the end of the acquirer’s reporting period or
the acquiree’s operations are extensive or unusually complex, the acquirer may require
additional time to obtain all of the data required to complete the acquisition accounting.
The objective of the measurement period is to provide a reasonable period of time for the
acquirer to obtain the information necessary to enable it to complete the accounting for a
business combination. The acquirer determines whether it has obtained all the
information it is seeking on an item-by-item basis, as it may be easier to obtain the
information needed to determine the fair value of certain acquired items than others.
10.001 The FASB determined that a reasonable time ends when the acquirer receives the
information it was seeking about facts and circumstances existing as of the acquisition
date, but in any event cannot continue for more than one year from the acquisition date.
In limiting the measurement period to a maximum of one year, the FASB concluded that
extending the measurement period beyond one year would not be particularly helpful,
because obtaining reliable information about circumstances and conditions that existed as
of an acquisition date more than a year earlier is likely to become more difficult as time
passes. The FASB also noted that, while the outcome of some contingencies and similar
items may not be known within a year, the purpose of the measurement period is to
provide time to obtain the information necessary to measure the items as of the
acquisition date, and that determining the ultimate settlement amount of a contingency is
not part of the acquisition accounting. Statement 141(R), par. B392
FINANCIAL REPORTING WHEN THE INITIAL ACCOUNTING FOR
A BUSINESS COMBINATION IS INCOMPLETE
REPORTING OF PROVISIONAL AMOUNTS
10.002 If the initial accounting for a business combination is not complete at the end of
the financial reporting period following the acquisition date, the acquirer reports
provisional amounts for the assets, liabilities, equity interests, or items of consideration
for which the accounting is incomplete. Because the acquirer evaluates whether it has the
information it seeks on an item-by-item basis, the amounts reported may be final for
certain items and provisional for others. ASC Topic 805, Business Combinations, does
not provide specific guidance on determining provisional amounts. We believe that those
amounts should be determined based on the available information at the acquisition date,
consistent with the recognition and measurement requirements of ASC Topic 805. We do
not believe it is appropriate to assign only nominal amounts, or no amounts, simply
because the acquirer anticipates receiving additional information about facts and
circumstances that existed as of the acquisition date.
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10. Measurement Period
DISCLOSURES
10.003 Until the accounting for a business combination is complete, the acquirer is
required to include additional disclosures in its financial statements. ASC paragraph 805-
20-50-4A specifies these disclosure requirements, which include, for particular assets,
liabilities, noncontrolling interests, or items of consideration for which the initial
accounting is incomplete and for which the amounts recognized in the financial
statements have been determined only provisionally:
(1) The reasons why the initial accounting is incomplete;
(2) The assets, liabilities, equity interests, or items of consideration for which the
initial accounting is incomplete; and
(3) The nature and amount of any measurement period adjustments recognized
during the reporting period in accordance with ASC paragraph 805-10-25-17.
10.004 The disclosures in an acquirer’s postcombination financial statements, when the
initial accounting for an acquisition is incomplete, should clearly identify the status of the
acquisition accounting, consistent with the level of detail required by ASC Topic 805.
Disclosures should include more than a general statement that the business combination
accounting is incomplete or that the measurement period still is open to meet those
disclosure requirements. The disclosures in the acquirer’s initial postcombination
financial statements following an acquisition should describe why the initial accounting
is incomplete, and the items in its financial statements for which the initial accounting is
incomplete. Postcombination financial statements issued during the measurement period
should describe the adjustments to the acquisition accounting during the most recent
reporting period, and update the other disclosures with respect to the status of the
acquisition accounting, including the items for which the initial accounting remains
incomplete. In making these disclosures, the acquirer should give consideration to the
following:
• The measurement period does not provide an open one-year period following
the acquisition date to complete the acquisition accounting. The measurement
period ends as soon as the acquirer receives the information it was seeking
about facts and circumstances that existed as of the acquisition date, or learns
that more information is not available. “However, in no circumstances may
the measurement period exceed one year from the acquisition date.” Statement
141(R), par. B392; ASC paragraph 805-10-25-14
• The required disclosures under ASC paragraph 805-20-50-4A should be
sufficiently detailed to identify the nature of the items for which the
acquisition accounting has not been completed. Thus, it would generally be
expected that subsequent adjustments to the acquisition accounting during the
measurement period would have been included in the ASC paragraph 805-20-
50-4A disclosures as an area of potential adjustment to the acquisition
accounting in any postcombination financial statements of the acquirer.
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10. Measurement Period
Additional assets acquired or liabilities assumed in an acquisition that were
not recognized at the acquisition date might be identified during the
measurement period. For example, new information obtained about facts and
circumstances that existed at the acquisition date might indicate that an
income tax uncertainty that was not recognized by the acquirer in the initial
accounting for an acquisition because it did not meet the more-likely-than-not
criterion for recognition at the acquisition date did, in fact, meet that criterion
at the acquisition date. Similarly, new information might be obtained about
facts and circumstances that existed at the acquisition date, but that were
unknown at that date, that indicate additional assets or liabilities (including
those arising from contingencies) not recognized in the initial accounting for
an acquisition should be recognized as part of the accounting for the
acquisition. ASC paragraphs 805-10-25-13 and 25-14 require an acquirer to
recognize additional assets or liabilities during the measurement period if it
obtains new information about facts and circumstances that existed as of the
acquisition date that, if known, would have resulted in the recognition of those
assets and liabilities at that date. Thus, an acquirer should assess the potential
for identifying additional assets or liabilities not recognized at the acquisition
date in making the disclosures required by ASC paragraph 805-20-50-4A
about provisional amounts. For example, unless an acquirer has a high level of
confidence that it has identified all liabilities assumed due to legal and
regulatory matters, including but not limited to those related to environmental
regulation and taxation arising from an acquisition, it should disclose the
status of its review and disclose the potential for adjustments to the
provisional amounts initially recognized. Such disclosure might be along the
following lines:
“[Acquiree] is subject to the legal and regulatory requirements, including
but not limited to those related to environmental matters and taxation, in
each of the jurisdictions in the 12 countries in which it operates.
[Acquirer] has conducted a preliminary assessment of liabilities arising
from these matters in each of these jurisdictions, and has recognized
provisional amounts in its initial accounting for the acquisition of
[Acquiree] for all identified liabilities in accordance with the requirements
of ASC Topic 805. However, [Acquirer] is continuing its review of these
matters during the measurement period, and if new information obtained
about facts and circumstances that existed at the acquisition date identifies
adjustments to the liabilities initially recognized, as well as any additional
liabilities that existed at the acquisition date, the acquisition accounting
will be revised to reflect the resulting adjustments to the provisional
amounts initially recognized.”
• Adjustments to provisional amounts, or recognition of additional assets
acquired or liabilities assumed, identified during the measurement period,
should be recognized as they are identified, even if the acquirer expects that
further adjustments might be needed during the measurement period. Thus, for
example, if an acquirer issues quarterly financial statements during the period
following an acquisition, those financial statements should reflect, on a
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10. Measurement Period
cumulative basis, any measurement period adjustments identified since the
issuance of financial statements for the previous reporting period(s).
Additionally, the disclosures required by ASC Topic 805, including those
required by ASC paragraph 805-20-50-4A for business combinations for
which the initial accounting is incomplete, are required to be included in
interim financial statements.
The SEC staff has challenged measurement period adjustments when there were no prior
disclosures by the acquirer about the reported amounts being provisional and why the
initial accounting was incomplete. Absent sufficient prior disclosures about the reported
amounts being provisional, the SEC staff ordinarily expects the accounting for those
items to be final. See the discussion of Disclosures in Section 13.
ADJUSTMENTS TO PROVISIONAL AMOUNTS DURING THE
MEASUREMENT PERIOD
IDENTIFYING ADJUSTMENTS TO PROVISIONAL AMOUNTS
ASC Paragraph 805-10-30-2
The acquirer shall consider all pertinent factors in determining whether
information obtained after the acquisition date should result in an adjustment to
the provisional amounts recognized or whether that information results from
events that occurred after the acquisition date. Pertinent factors include the time at
which additional information is obtained and whether the acquirer can identify a
reason for a change to provisional amounts.
ASC Paragraph 805-10-30-3
Information that is obtained shortly after the acquisition date is more likely to
reflect circumstances that existed at the acquisition date than is information
obtained several months later. For example, unless an intervening event that
changed its fair value can be identified, the sale of an asset to a third party shortly
after the acquisition date for an amount that differs significantly from its
provisional fair value determined at that date is likely to indicate an error in the
provisional amount.
10.005 In many instances, it will be clear whether information obtained after the
acquisition date (but within the measurement period) relates to facts and circumstances
that existed at the acquisition date and should, therefore, result in an adjustment to the
provisional amounts recognized, or whether the additional information relates to events
that occurred after the acquisition date and should, therefore, be accounted for as events
of the postcombination period. However, in other instances, whether an event should be
recognized as an adjustment to a provisional amount or as a postcombination event will
be less clear, and will require analysis and judgment. See the discussion in Paragraph
10.007 about the analogy of measurement period adjustments to recognized subsequent
events under ASC Subtopic 855-10, Subsequent Events - Overall.
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10. Measurement Period
10.006 Even if additional information related to circumstances and conditions that existed
as of the acquisition date comes to light during the measurement period, such information
results in adjustments to the provisional amounts recognized at the acquisition date only
if:
• The additional information affects the measurement of items that were
initially recognized at the acquisition date;
• The additional information establishes that an additional asset was acquired or
a liability was assumed that was not recognized in the initial accounting for
the acquisition; or
• An asset or a liability was recognized at the acquisition date, and the
subsequent information establishes that such asset or liability did not meet the
recognition requirements of ASC Topic 805 at that date.
10.007 In considering the nature of postcombination adjustments, the FASB concluded
that adjustments to provisional amounts during the measurement period are analogous to
recognized subsequent events in ASC Subtopic 855-10. Recognized subsequent events
are events that occur after the balance sheet date but before financial statements are
issued or are available to be issued, that provide additional evidence about conditions that
existed at the financial statements balance sheet date (including the estimates inherent in
the process of preparing financial statements) and, thus, are reflected in the financial
statements as if they had been initially recognized at that date. Similarly, the effects of
information that first becomes available during the measurement period and provides
evidence of conditions or circumstances that existed at the acquisition date should be
reflected in the accounting as of the acquisition date. Statement 141(R), par. B399
(revised to reflect changes in accounting guidance and terminology in ASC Subtopic 855-
10); ASC paragraphs 805-10-30-2 and 30-3
Example 10.1: Use of Hindsight When Measuring the Fair Value of
Contingent Consideration
ABC Corp. acquires DEF Corp. on February 28, 20X4. The acquisition agreement calls
for ABC to pay the former shareholders of DEF additional consideration based on the
performance of DEF's business for the two years after the acquisition date. Based on the
due diligence performed at the acquisition date, the fair value of the contingent
consideration is estimated to be $20 million.
DEF's performance in the 10 months after the acquisition date has been significantly
better than anticipated, in part because of better synergies in integrating DEF's operations
into ABC's existing distribution channels. As a consequence, at December 31, 20X4
(which is within the measurement period), the fair value of the contingent consideration
is estimated to be $50 million.
The adjustment to the contingent consideration would not constitute a measurement
period adjustment because it reflects new conditions (i.e., improved performance of DEF)
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10. Measurement Period
rather than more information about conditions that existed at the acquisition date.
Therefore, the $30 million adjustment to the fair value of the contingent consideration is
included in income for the year ended December 31, 20X4.
Example 10.2: Information Becomes Available before and Shortly after the
Measurement Period Ends
ABC Corp. acquires DEF Corp. on April 30, 20X8. Provisional amounts are recognized
for certain of the assets acquired and liabilities assumed, including a liability related to a
contractual dispute between DEF and one of its customers. DEF completed the contract
before the acquisition date, but its customer claimed, shortly before the acquisition date,
that certain amounts were due to the customer from DEF under penalty clauses for
completion delays included in the contract. ABC evaluated the dispute based on the
information available at the acquisition date, and concluded that DEF was responsible for
at least some of the delays in completing the contract. ABC recognized a provisional
amount for this liability in its acquisition accounting of $1 million, which was its best
estimate of the fair value of the liability to the customer based on the information
available at the acquisition date.
ABC obtained no new information about the possible outcome of the dispute until
September 20X8 and it continued to reflect the liability at the provisional amount of $1
million. However, in September 20X8, based on its evaluation of additional information
presented by the customer in support of its claim, ABC concluded that the fair value of
the liability for the customer’s claim at the acquisition date was $2 million.
ABC continued to receive and evaluate information related to the claim after September
20X8, but its evaluation did not change until May 15, 20X9, when it concluded, based on
additional information and responses received from the customer to inquiries made by
ABC, that the liability for the claim at the acquisition date was $1.9 million. ABC
determined that the amount that would otherwise be recognized with respect to the claim
under ASC Topic 450, Contingencies (i.e., if the claim had not arisen from a contingency
existing at the acquisition date) as of May 15, 20X9, would be $2.2 million.
ABC’s accounting for changes to the liability provisionally recognized for this dispute at
the acquisition date is:
• ABC increases the provisional amount of $1 million recognized as a liability
at the acquisition date to $2 million in September 20X8, because this
adjustment results from new information about facts and circumstances that
existed at the acquisition date and falls within the measurement period.
The decrease in the estimated fair value of the liability for the claim (from $2 million to
$1.9 million) in May 20X9 occurred after the measurement period (i.e., more than one
year after the acquisition date), and would therefore not be recognized as an adjustment
to the acquisition accounting. However, because the amount determined in accordance
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with ASC Topic 450 ($2.2 million) now exceeds the fair value of the liability recognized
under ASC Topic 450 ($2 million), and because the information resulting in this change
was obtained after the end of the measurement period, ABC would recognize an increase
in the liability of $.2 million, and an offsetting charge to earnings. See discussion of the
subsequent measurement and accounting for Assets and Liabilities Arising from
Contingencies, in Section 12.
ADJUSTMENTS TO PROVISIONAL AMOUNTS ARE REPORTED IN THE
SUBSEQUENT PERIOD
ASC Paragraph 805-10-25-16
The acquirer recognizes an increase (decrease) in the provisional amount
recognized for an identifiable asset (liability) by means of a decrease (increase) in
goodwill. However, new information obtained during the measurement period
sometimes may result in an adjustment to the provisional amount of more than
one asset or liability. For example, the acquirer might have assumed a liability to
pay damages related to an accident in one of the acquiree’s facilities, part or all of
which are covered by the acquiree’s liability insurance policy. If the acquirer
obtains new information during the measurement period about the acquisition-
date fair value of that liability, the adjustment to goodwill resulting from a change
to the provisional amount recognized for the liability would be offset (in whole or
in part) by a corresponding adjustment to goodwill resulting from a change to the
provisional amount recognized for the claim receivable from the insurer.
ASC Paragraph 805-10-25-17
During the measurement period, the acquirer shall recognize adjustments to the
provisional amounts with a corresponding adjustment to goodwill in the reporting
period in which the adjustments to the provision amounts are determined. Thus,
the acquirer shall adjust its financial statements as needed, including recognizing
in its current-period earnings the full effect of changes in depreciation,
amortization, or other income effects, by line item, if any, as a result of the
change to the provisional amounts calculated as if the accounting had been
completed at the acquisition date. Paragraph 805-10-55-16 and Example 1 (see
paragraph 805-10-55-27) provide additional guidance.
10.008 An acquirer is required to recognize adjustments to provisional amounts identified
during the measurement period in the period they are identified, and to recognize such
adjustments in the current period as if the accounting for the business combination had
been completed at the acquisition date (i.e., on a cumulative basis in the period of the
adjustment). These adjustments may relate to the measurement of initially recognized
assets acquired or liabilities assumed, identification of additional assets acquired or
liabilities assumed, and previously recognized assets or liabilities that do not meet the
recognition criteria of ASC Topic 805, based on new information about the facts and
circumstances that existed at the acquisition date. The current financial statements would
reflect the cumulative adjustments to provisional amounts identified during the
measurement period, including any adjustments to the assets acquired (including
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10. Measurement Period
indemnification assets), the liabilities assumed, related deferred taxes, goodwill, and any
change in depreciation, amortization, or other income effects as a result of the
adjustments.
OTHER EXAMPLES OF MEASUREMENT PERIOD
ADJUSTMENTS
10.009 Examples 10.3 through 10.9 illustrate the accounting for adjustments to assets
acquired and liabilities assumed in an acquisition that are identified during the
measurement period. All adjustments in the examples are deemed to be material for
purposes of illustration. Income tax considerations are not addressed in the examples. It is
assumed for purposes of each of these examples that, when amounts recognized in the
financial statements for the first reporting period following the acquisition are based on
provisionally determined amounts, the disclosures required by ASC paragraph 805-20-
50-4A were included in those financial statements.
INCOMPLETE VALUATION INFORMATION AT THE REPORTING DATE
10.010 An acquirer may not have obtained the valuation information required to finalize
the accounting for certain assets acquired and liabilities assumed in an acquisition by the
time it issues its financial statements for the first reporting period following an
acquisition. In such instances, the acquiree assigns provisional amounts to the acquired
asset or liability assumed, based on an evaluation of the information available at that
time.
ASC Paragraph 805-10-55-27
This Example illustrates the measurement period guidance in paragraph 805-10-
55-16. Acquirer acquires Target on September 30, 20X7. Acquirer seeks an
independent appraisal for an item of property, plant, and equipment acquired in
the combination, and the appraisal was not complete by the time Acquirer issued
its financial statements for the year ending December 31, 20X7. In its 20X7
annual financial statements, Acquirer recognized a provisional fair value for the
asset of $30,000. At the acquisition date, the item of property, plant, and
equipment had a remaining useful life of five years. Six months after the
acquisition date, Acquirer received the independent appraisal, which estimated the
asset’s acquisition-date fair value as $40,000.
ASC Paragraph 805-10-55-28
In its interim financial statements for the quarter ending March 31, 20X8,
Acquirer adjusts the provisional amounts recorded and the related effects on that
period's earnings as follows:
a. The carrying amount of property, plant, and equipment as of March 31,
20X8, is increased by $9,000. That adjustment is measured as the fair value
adjustment at the acquisition date of $10,000 less the additional depreciation
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10. Measurement Period
that would have been recognized had the asset’s fair value at the acquisition
date been recognized from that date ($1,000 for 6 months’ depreciation).
b. The carrying amount of goodwill as of March 31, 20X8, is decreased by
$10,000.
c. Depreciation expense for the quarter ended March 31, 20X8 is increased by
$1,000 to reflect the effect on earnings as a result of the change to the
provisional amount recognized.
ASC Paragraph 805-10-55-29
In accordance with ASC paragraph 805-20-50-4A, Acquirer discloses both of the
following:
a. In its 20X7 financial statements, that the initial accounting for the business
combination has not been completed because the appraisal of property, plant,
and equipment has not yet been received
b. In its March 31, 20X8 financial statements, the amounts and explanations
of the adjustments to the provisional values recognized during the current
reporting period. Therefore, Acquirer discloses that the increase to the fair
value of the item of property, plant, and equipment was $10,000 with a
corresponding decrease to goodwill. Additionally, the change to the
provisional amount resulted in an increase in depreciation expense and
accumulated depreciation of $1,000, of which $500 relates to the previous
quarter.
Example 10.3: Appraisal Received during the Measurement Period
Identifies Decrease in Fair Value Occurring after the Acquisition Date
ABC Corp. acquires DEF Corp. in December 20X8. The fair value of DEF’s
headquarters and surrounding property was estimated to be $10 million. In May 20X9,
ABC obtained an appraisal for the property that indicated a current fair value of $8
million. The appraisal also confirmed the property’s acquisition-date fair value of $10
million, and indicated that the subsequent decline in fair value was due to an unexpected
change in zoning and land-use laws proposed three months after the acquisition date.
Comparable real estate in the same market area also declined significantly as a result of
the proposed changes in zoning and land-use laws. ABC concluded that there were no
other factors that may have affected the acquisition-date fair value of the property.
In this case, the decline in fair value of the property would not be a measurement period
adjustment, because an event after the acquisition (the proposed change in zoning and
land-use laws) caused the property value decline. Accordingly, ABC would not adjust the
provisionally determined amount recognized in the initial accounting for the acquisition.
ABC would perform an impairment test under ASC paragraphs 360-10-35-15 through
35-42, to determine if recognition of an impairment loss is required.
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10. Measurement Period
Example 10.4: Pension Plan Valuation Not Completed at the Acquisition
Date
ABC Corp. acquired DEF Corp. in a business combination in August 20X7. At the
acquisition date, ABC provisionally recognized a liability of $200 related to DEF’s
pension plan, based on an actuarial valuation report as of December 20X6 with a
rollforward adjustment for the period from the measurement date of the valuation report
to the acquisition date, because the calculation of the projected benefit obligation and the
information concerning the fair value of the plan assets as of the acquisition date was not
available. The remeasurement of the projected benefit obligation and the fair value of
plan assets related to DEF’s pension plan as of the acquisition date was not completed
until November 20X7. This remeasurement reflected an excess of the projected benefit
obligation over plan assets of $300 as of the acquisition date. ABC evaluated the reasons
for the difference between the provisionally recognized and the finally determined
projected benefit obligation, and determined that the differences did not result from an
error in the calculation of the provisionally recognized amount, but rather resulted from
using the updated information that was not available until November 20X7.
ABC should recognize the additional $100 excess of the projected benefit obligation over
plan assets as a $100 increase in the provisional liability recognized at the acquisition
date, with an offsetting adjustment recognized as an increase in goodwill or a reduction in
the gain on a bargain purchase, as applicable. These adjustments would be included in the
quarter that includes November 20X7. The impact on net pension cost for the period
August 20X7 - November 20X7 would be included in the net pension cost recognized for
the quarter that included November 20X7. Net pension cost for periods subsequent
November 20X7 would be determined based on the unfunded projected benefit obligation
of $300, which includes the effect of the measurement period adjustment identified
subsequent to the acquisition.
OBLIGATION FOR DEFECTIVE PRODUCTS
Example 10.5: New Information on Defective Product Liability Obtained
during the Measurement Period
ABC Corp. acquired DEF Corp. in a business combination in December 20X8. As of the
acquisition date, DEF had established a liability for its warranty obligation for product
defects on products sold to 25 customers. DEF had reviewed the customers’ claims and
concluded, pending actual product testing, that it was obliged under its product warranty
to either make repairs or replace certain product components. ABC agreed with DEF’s
assessment and recognized a liability in the provisional amount of $1,000 (25 × $40), the
estimated fair value of the liability, as part of its accounting for the acquisition of DEF. In
April 20X9, on completion of product testing, ABC concluded that it would be required
to replace the defective products in their entirety, and estimated the fair value of the
liability for total product replacement as of the acquisition date to be $5,000 (25 × $200).
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10. Measurement Period
DEF’s liability for defective products existed as of the acquisition date. The new
information received in April 20X9 related to facts and circumstances that existed at the
acquisition date. Accordingly, ABC would therefore recognize an increase of $4,000 (25
× ($200 - $40)) in the provisional amount of the liability recognized at the acquisition
date, and a corresponding increase in goodwill (or as an adjustment to the gain from a
bargain purchase, if applicable) in the quarter that includes April 20X9.
LOANS ACQUIRED IN AN ACQUISITION
Example 10.6: New Information on the Fair Value of an Acquired Loan
Obtained during the Measurement Period
Bank X acquired Bank Y in a business combination. In measuring the fair value of Bank
Y’s loan portfolio, Bank X recognizes a loan to one of the Bank’s customers, Borrower
Z, at its provisionally determined fair value. Subsequent to the acquisition date, Bank Y
received financial statements from Borrower Z as of Borrower Z’s most recent year-end
(which preceded the acquisition date), which indicated that the income from operations of
Borrower Z had declined significantly during the past year. Based on this new
information, Bank X concluded that the fair value of Borrower Z’s loan at the acquisition
date was less than the provisional amount recognized at that date.
The new information obtained by Bank X subsequent to the acquisition related to facts
and circumstances that existed at the acquisition date. Accordingly, Bank X should
recognize a decrease in the provisional amount recognized for Borrower Z’s loan to the
fair value of the loan determined based on the new information, and a corresponding
increase in goodwill (or a decrease in the gain from a bargain purchase, if applicable) in
the quarter in which the updated information is obtained.
Example 10.7: Decrease in Fair Value of Acquired Loan Resulting from an
Event Occurring during the Measurement Period
Bank X acquired Bank Y in a business combination. In measuring the fair value of Bank
Y’s loan portfolio, Bank X recognizes a loan to one of Bank Y’s customers, Borrower Z,
at its provisionally determined fair value. Subsequent to the acquisition date, Bank X
learned that Borrower Z had lost its major customer (the loss of its major customer
occurred after the acquisition date), which is expected to have a significant negative
effect on the operations of Borrower Z. Based on this new information, Bank X
determined that the fair value of the loan to Borrower Z was significantly less than the
amount that had been provisionally determined at the acquisition date.
The new information resulting in the change in the estimated fair value of the loan was
not due to facts and circumstances that existed at the acquisition date, but rather was due
to an event (the loss of a major customer by Borrower Z) that occurred subsequent to the
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10. Measurement Period
acquisition date. Therefore, based on the new information, Bank X would determine the
amount of any allowance for loss on the loan in accordance with the applicable GAAP,
and the offsetting adjustment would be charged to earnings in Bank X’s postcombination
financial statements.
NEW INFORMATION OBTAINED ON A CONTINGENCY IDENTIFIED PRE-
COMBINATION
Example 10.8: Contingency Existed but Additional Information Identified
after the Acquisition Date
ABC Corp. acquired DEF Corp. in a business combination in April 20X8. ABC identified
a contingency during due diligence related to the trade practices of a subsidiary of DEF.
ABC was still in the process of obtaining information related to the contingency at the
acquisition date and disclosed this as an item subject to potential adjustment during the
measurement period. As sufficient information was not available, ABC did not record a
liability at the acquisition date. The acquisition agreement included a $20 million
indemnification of potentially identified contingencies. ABC caused DEF to discontinue
such trading practices immediately following the acquisition.
In February 20X9, before ABC obtained all relevant information about the facts related to
the contingency that existed at the acquisition date, the Department of Justice publicly
announced the start of a formal investigation into the trade practices of a subsidiary of
DEF related to activities that occurred during a three-year period that ended prior to the
acquisition date. Based on the subsequent announcement of the investigation into the
trade practices of DEF and on the records available related to the period under
investigation, ABC concludes that, while the acquisition-date fair value of the liability is
not determinable, it is probable that DEF’s trade practices during the period under
investigation violated the applicable laws and estimates the amount of the unasserted
claim at the acquisition date to be $30 million. In addition, after seeking advice from
legal counsel, ABC concludes that it has recourse against the previous shareholders of
DEF up to the $20 million from the indemnification clause in the acquisition agreement,
and has responsibility for any remaining loss arising from claims related to the
investigation.
The contingency existed as of the acquisition date; however, ABC did not obtain the
additional information until after the acquisition date but before the end of the
measurement period. If ABC had been aware of this information at the acquisition date, it
would have recognized a liability as of that date. Therefore, ABC should record a
measurement period adjustment to reflect the $30 million estimated amount of the
liability related to the contingency, consistent with ASC paragraph 805-10-25-16, offset
by the indemnification asset of $20 million, as well as a corresponding increase in
goodwill.
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10. Measurement Period
AFTER THE MEASUREMENT PERIOD ENDS, THE ACQUISITION ACCOUNTING IS
ADJUSTED ONLY TO CORRECT ERRORS
ASC Paragraph 805-10-25-19
After the measurement period ends, the acquirer shall revise the accounting for a
business combination only to correct an error in accordance with [ASC] Topic
250.
10.011 Because the measurement period extends for a maximum period of one year
following the acquisition date, no further adjustments are made to the acquisition
accounting thereafter except to correct an error. If errors in the acquisition accounting are
discovered during the measurement period, but after postcombination financial
statements have been issued, adjustments to the postcombination financial statements to
correct the error should also be accounted for as the correction of an error under ASC
Topic 250, Accounting Changes and Error Corrections.
10.012 – 10.015 Paragraphs not used.
Example 10.9: Error Discovered after the End of the Measurement Period
Case 1: New Information Obtained after the End of the Measurement Period
ABC Corp., a calendar-year-end nonpublic entity, acquired DEF Corp. in a business
combination in November 20X8. The measurement period ended in November 20X9. In
January 20Y0, before issuance of its 20X9 financial statements, ABC obtained new
information about facts and circumstances that existed as of the acquisition date that, if
known, would have resulted in the recognition of an additional liability at that date.
In this case, because the measurement period has ended and the adjustment resulting from
the new information is not the result of an error, ABC would not adjust the acquisition
accounting. Instead, it would treat the new information as a recognized subsequent event
with respect to its 20X9 financial statements and, accordingly, would reflect the effect of
the adjustment resulting from the new information in its 20X9 financial statements by
recognizing the additional liability through a charge to earnings.
Case 2: Error Discovered after the End of Measurement Period
Assume the same facts as in Case 1, except that ABC concluded that the new information
it obtained in January 20Y0 indicated that it had made an error in the acquisition
accounting due to the misuse of facts that existed at the acquisition date.
In this case, if the effects were material, ABC would restate its financial statements as of
the date the information was deemed to be initially available (which could be the period
that includes the acquisition date or any of the subsequent interim periods until the end of
the measurement period (and any subsequent interim period financial statements after
that date) to correct the error in the acquisition accounting by recognizing the liability as
of the acquisition date and adjusting goodwill (or the gain on a bargain purchase) by the
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10. Measurement Period
corresponding amount, and making any cumulative adjustments needed to its results of
operations resulting from the error. ABC also would determine whether any other actions
were necessary as a result of the restatement of such financial statements.
ADJUSTMENTS TO PROVISIONAL AMOUNTS RELATED TO
DEFERRED TAX ASSETS AND LIABILITIES DURING THE
MEASUREMENT PERIOD
ASC Paragraph 805-740-25-2
An acquirer shall recognize a deferred tax asset or deferred tax liability arising
from the assets acquired and liabilities assumed in a business combination and
shall account for the potential tax effects of temporary differences, carryforwards,
and any income tax uncertainties of an acquiree that exist at the acquisition date,
or that arise as a result of the acquisition, in accordance with the guidance in
[ASC] Subtopic 740-10 [Income Taxes - Overall] together with the incremental
guidance provided in [ASC] Subtopic [805-740].
10.016 Prior to the issuance of ASC Topic 805 and the related amendments to ASC
Subtopic 740-10, Income Taxes - Overall, ASC Subtopic 740-10 required that the tax
benefits arising subsequent to an acquisition (as a result of the initial elimination of a
valuation allowance recognized at the acquisition date for an acquiree’s deductible
temporary differences or operating loss or tax credit carryforwards) be applied (a) first to
reduce to zero any goodwill related to the acquisition, (b) second to reduce to zero other
noncurrent intangible assets related to the acquisition, and (c) third to reduce income tax
expense.
10.017 In deliberating ASC Topic 805, the FASB concluded that an acquirer should
recognize changes in amounts recognized for acquired deferred tax benefits of an
acquiree (both increases and decreases) in the same manner as revisions to other amounts
recognized at the acquisition date.
ASC Paragraph 805-740-45-2
The effect of a change in a valuation allowance for an acquired entity’s deferred
tax asset shall be recognized as follows:
a. Changes within the measurement period that result from new information
about facts and circumstances that existed at the acquisition date shall be
recognized through a corresponding adjustment to goodwill. However, once
goodwill is reduced to zero, an acquirer shall recognize any additional
decrease in the valuation allowance as a bargain purchase in accordance with
[ASC] paragraphs 805-30-25-2 through 25-4. See paragraphs 805-10-25-13
through 25-19 and 805-10-30-2 through 30-3 for a discussion of the
measurement period in the context of a business combination.
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10. Measurement Period
b. All other changes shall be reported as a reduction or increase to income tax
expense (or a direct adjustment to contributed capital as required by [ASC]
paragraphs 740-10-45-20 through 45-21).
10.018 The FASB also revised ASC Subtopic 740-10 to provide similar guidance for the
subsequent accounting for adjustments to amounts recognized for acquired income tax
uncertainties. Therefore, the same approach is used in accounting for such adjustments as
is required for subsequent adjustments to acquired deferred tax benefits:
ASC Paragraph 805-740-45-4
The effect of a change to an acquired tax position, or those that arise as a result of
the acquisition, shall be recognized as follows:
a. Changes within the measurement period that result from new information
about facts and circumstances that existed as of the acquisition date shall be
recognized through a corresponding adjustment to goodwill. However, once
goodwill is reduced to zero, the remaining portion of that adjustment shall be
recognized as a gain on a bargain purchase in accordance with [ASC]
paragraphs 805-30-25-2 through 25-4.
b. All other changes in acquired income tax positions shall be accounted for in
accordance with the accounting requirements for tax positions established in
[ASC] Subtopic 740-10.
10.019 As a result of these requirements, the accounting for subsequent adjustments to
amounts recognized at the acquisition date for acquired deferred tax benefits and acquired
income tax uncertainties is the same. That is, retrospective adjustments to amounts
recognized at the acquisition date are limited to adjustments that result from new
information obtained during the measurement period about facts and circumstances that
existed as of the acquisition date. All other changes in amounts recognized at the
acquisition date are recognized and measured in accordance with ASC Subtopic 740-10.
Additionally, because of ASC Topic 805’s transition provisions related to income taxes,
this accounting applies to all adjustments to acquired deferred tax benefits and acquired
income tax uncertainties, including adjustments related to amounts recognized in
business combinations consummated before the effective date of ASC Topic 805. See the
discussion of the subsequent accounting for income taxes following a business
combination in KPMG Handbook, Accounting for Income Taxes, Section 6.
CONTINGENT CONSIDERATION
10.020 The consideration issued by the acquirer in exchange for the acquiree includes a
liability (or an asset) arising from a contingent consideration arrangement, measured and
recognized at its acquisition-date fair value. Provisional amounts for contingent
consideration recognized at the acquisition date are adjusted only for adjustments
identified during the measurement period that result from new information obtained
about facts and circumstances that existed as of the acquisition date that, if known, would
have affected the measurement of the amounts recognized at the acquisition date. All
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10. Measurement Period
other changes in fair value after the acquisition date, including those occurring within the
measurement period, do not affect the acquisition date accounting. See the discussions of
the initial recognition and measurement of contingent consideration, and the subsequent
accounting for contingent consideration under Contingent Consideration, in Sections 6
and 12, respectively.
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Section 11 - Determining What Is Part of
the Business Combination Transaction
Detailed Contents
Example 11.0: Costs of Introducing New Processes to an Acquiree before a
Business Combination
Preexisting Relationships
Settlement of Preexisting Relationships
Preexisting Noncontractual Relationships
Example 11.1: Preexisting Noncontractual Relationship
Preexisting Contractual Relationships
Example 11.2: Effective Settlement of a Supply Contract as a Result of a Business
Combination
Example 11.3: Effective Settlement of a Contract between the Acquirer and
Acquiree in Which the Acquirer Had Recognized a Liability before the Business
Combination
Example 11.4: Effective Settlement of a License Contract between the Acquirer
and Acquiree
Example 11.4a: Effective Settlement of Accounts Receivable
Example 11.5: Reacquired Rights with Off-Market Terms
Transactions That Compensate Employees or Former Owners of the Acquiree for
Services
Example 11.6: Arrangement for Contingent Payment to an Employee
Example 11.7: Arrangement for Contingent Payment to an Employee at the
Suggestion of the Acquirer
Example 11.7a: Arrangement for Bonuses to Be Paid by the Acquirer to
Employees
Example 11.7b: Rollover Equity not Compensatory
Additional Indicators for Evaluating Arrangements for Contingent Payments to
Employees or Selling Shareholders
Arrangements for Contingent Payments to Employees or Selling Shareholders That
Are Forfeited if Employment Terminates
Example 11.8: Stay Bonuses - Scenario 1
Example 11.9: Stay Bonuses - Scenario 2
Example 11.10: Shareholders/Executive Officers - Scenario 1
Example 11.11: Shareholders/Executive Officers - Scenario 2
Example 11.12: Executive Officers - Double Trigger Awards
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11. Determining What Is Part of the Business Combination Transaction
Example 11.12a: Contingent Employee Compensation Paid to Selling
Shareholder if Forfeited by Employee
Transition Service Agreements (TSAs)
Forgiveness of Full-Recourse Loans
Acquirer Share-Based Payment Awards Exchanged for Awards Held by the Grantees of
the Acquiree
Attribution of Replacement Awards to Consideration Transferred and Post-
combination Vesting
Measurement
Attribution - Employee Awards
Example 11.13: Acquirer Replacement Awards That Require No Post-
combination Vesting Exchanged for Acquiree Awards for Which Employees
Have Rendered the Required Services as of the Acquisition Date
Example 11.14: Recording Replacement Awards that Provide Additional Fair
Value if Post-combination Vesting Is Rendered
Example 11.15: Acquirer Replacement Awards That Require Post-combination
Vesting Exchanged for Acquiree Awards for Which Employees Have Rendered
the Requisite Service as of the Acquisition Date
Example 11.16: Acquirer Replacement Awards That Require Post-combination
Vesting Exchanged for Acquiree Awards for Which Employees Have Not
Rendered All of the Requisite Service as of the Acquisition Date
Example 11.17: Acquirer Replacement Awards for Which No Post-combination
Vesting Is Required Exchanged for Acquiree Awards for Which Employees Have
Not Rendered All of the Requisite Service as of the Acquisition Date
(Pre-ASU 2018-07) Attribution - Nonemployees
Example 11.17a: Share Options Granted to Nonemployees in a Business
Combination
(Post-ASU 2018-07) Attribution - Nonemployees
Example 11.17b: Acquirer Replacement Awards That Require Post-combination
Vesting Exchanged for Acquiree Awards for Which Nonemployees Have Not
Delivered all of the Goods or Services as of the Acquisition Date
Accounting for Forfeitures of Replacement Awards in a Business Combination
Example 11.17c: Effect of Acquirer’s Forfeiture Accounting Policy on Post-
Acquisition Accounting for Replacement Share-Based Payment Awards
Awards with Graded Vesting - Employee Awards
Example 11.18: Graded Vesting Replacement Awards
Example 11.18a: Graded Vesting Replacement Awards – Part II
Settlement of Share-Based Awards
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11. Determining What Is Part of the Business Combination Transaction
Example 11.19: Acquirer Cash Settles an Acquiree's Award
Change-in-Control Provisions
Example 11.19a: Settlement of Share Awards on Consummation of a Business
Combination
Example 11.20: Original Share-Based Payment Award Provides for Accelerated
Vesting on Change in Control
Example 11.21: Acquiree Initiates Modification of Share-Based Compensation
Awards in Contemplation of a Change in Control
Example 11.22: Modifications of Acquiree Share-Based Compensation Award at
the Request of the Acquirer in Contemplation of a Change in Control
Awards with Performance Conditions
Awards with Market Conditions
Post-Acquisition Changes in Estimates
Last-Man-Standing Plans
Example 11.23: Last-Man-Standing Plans
Acquisition of Noncontrolling Interest
Example 11.23a: Treatment of the Exchange of Awards in the Acquisition of
Noncontrolling Interest
Example 11.23b: Accounting for the Exchange of Partially Vested Awards at the
Acquisition Date of the Subsidiary
Example 11.23c: Accounting for the Exchange of Fully Vested Awards Issued
after the Acquisition Date of the Subsidiary
Acquirer's Accounting for Unreplaced Awards
Acquirer’s Subsequent Grant of Awards When Acquirer Did Not Exchange Acquiree’s
Awards in the Business Combination Transaction
Example 11.23a: Employee Share Options of Acquiree That Are Not Assumed by
the Acquirer
Payroll Taxes on Share-Based Awards
Accounting for the Income Tax Effects of Replacement Awards Classified as Equity
Issued in a Business Combination
Acquisition-Related Costs
Acquisition-Related Costs Incurred by the Acquirer
Example 11.26: Acquisition-Related Costs
Q&A 11.1: Costs Related to Directors and Officers Liability Insurance
Costs Related to the Issuance of Equity Securities
Costs Related to the Issuance of Debt
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11. Determining What Is Part of the Business Combination Transaction
Other Payments to an Acquiree (or its Former Owners) That Are Not Part of the
Consideration Transferred
Example 11.27: Acquisition-Related Payments Made by an Acquiree
Other Transactions
Changes in Interest Rate on Acquirer's Debt Resulting from a Change in Control
Costs Contingent on a Business Combination
Hedging a Forecasted Transaction Contingent on Consummation of a Business
Combination
Example 11.28: Derivative Transaction That Will Lock In the Interest Rate Today
on the Forecasted Issuance of Debt Expected to Occur in Six Months
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11. Determining What Is Part of the Business Combination Transaction
ASC Paragraph 805-10-25-20
The acquirer and the acquiree may have a preexisting relationship or other
arrangement before negotiations for the business combination began, or they may
enter into an arrangement during the negotiations that is separate from the
business combination. In either situation, the acquirer shall identify any amounts
that are not part of what the acquirer and the acquiree (or its former owners)
exchanged in the business combination, that is, amounts that are not part of the
exchange for the acquiree. The acquirer shall recognize as part of applying the
acquisition method only the consideration transferred for the acquiree and the
assets acquired and liabilities assumed in the exchange for the acquiree. Separate
transactions shall be accounted for in accordance with the relevant generally
accepted accounting principles (GAAP).
ASC Paragraph 805-10-25-21
A transaction entered into by or on behalf of the acquirer or primarily for the
benefit of the acquirer or the combined entity, rather than primarily for the benefit
of the acquiree (or its former owners) before the combination, is likely to be a
separate transaction. The following are examples of separate transactions that are
not to be included in applying the acquisition method:
a. A transaction that in effect settles preexisting relationships between the
acquirer and acquiree (see [ASC] paragraphs 805-10-55-20 through 55-23)
b. A transaction that compensates employees or former owners of the acquiree
for future services (see [ASC] paragraphs 805-10-55-24 through 55-26)
c. A transaction that reimburses the acquiree or its former owners for paying
the acquirer's acquisition-related costs (see [ASC] paragraph 805-10-25-23).
11.000 An acquirer is required to identify amounts that are not part of the exchange for
the acquiree. Such amounts are not included in the accounting for the business
combination, but rather are accounted for as separate transactions in accordance with
other relevant GAAP. If a method of allocating consideration is not specifically
addressed by other relevant GAAP, we believe allocating amounts based on relative fair
value is a reasonable approach.
11.001 Determining what is part of the business combination involves an analysis of the
relevant factors of the arrangement. The FASB observed that parties directly involved in
the negotiations of a business combination may take on the characteristics of related
parties, and thus may be willing to enter into other agreements or include as part of the
business combination agreement some arrangements that are designed primarily for the
benefit of the acquirer or the combined entity (for example, to achieve more favorable
financial reporting outcomes after the business combination). ASC paragraph 805-10-25-
21 provides three examples of transactions that are not part of a business combination and
which should therefore be accounted for separately in accordance with other relevant
GAAP. The determination as to whether an asset or liability is part of a business
combination transaction rather than an asset or a liability resulting from a separate
transaction requires an acquirer to identify the components of a transaction in which it
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11. Determining What Is Part of the Business Combination Transaction
obtains control over an acquiree. The objective of making the distinction is to ensure that
each component is accounted for in accordance with its economic substance. ASC
paragraphs 805-10-25-20 through 25-22 and 55-18.
11.002 The implementation guidance in ASC paragraph 805-10-55-18 provides factors
(which are not mutually exclusive or individually conclusive) to be considered in
assessing whether a transaction is part of a business combination or is a separate
transaction and should be accounted for separately in accordance with other relevant
GAAP.
(a) The reasons for the transaction-Understanding the reasons why the parties to
the combination (the acquirer, the acquiree, and their owners, directors,
managers, and their agents) entered into a particular transaction or
arrangement may provide insight into whether it is part of the consideration
transferred and the assets acquired or liabilities assumed. For example, if a
transaction is arranged primarily for the benefit of the acquirer or the
combined entity rather than primarily for the benefit of the acquiree or its
former owners before the combination, that portion of the transaction price
paid (and any related assets or liabilities) is less likely to be part of the
exchange for the acquiree. Accordingly, the acquirer would account for that
portion separately from the business combination.
(b) Who initiated the transaction-Understanding who initiated the transaction may
also provide insight into whether it is part of the exchange for the acquiree.
For example, a transaction or other event that is initiated by the acquirer may
be entered into for the purpose of providing future economic benefits to the
acquirer or combined entity with little or no benefit received by the acquiree
or its former owners before the combination. On the other hand, a transaction
or arrangement initiated by the acquiree or its former owners is less likely to
be for the benefit of the acquirer or the combined entity and more likely to be
part of the business combination transaction.
(c) The timing of the transaction-The timing of the transaction may also provide
insight into whether it is part of the exchange for the acquiree. For example, a
transaction between the acquirer and the acquiree that takes place during the
negotiations of the terms of a business combination may have been entered
into in contemplation of the business combination to provide future economic
benefits to the acquirer or the combined entity. If so, the acquiree or its former
owners before the business combination are likely to receive little or no
benefit from the transaction except for benefits they receive as part of the
combined entity.
11.003 In many instances, it will be readily apparent, giving consideration to the specific
circumstances including the above factors, whether a transaction or arrangement is part of
the business combination or relates to events or transactions that are not a part of the
business combination and should therefore be accounted for in accordance with other
relevant GAAP. For example, the settlement of matters that arose prior to the
consideration of a business combination between the acquirer and the acquiree, such as a
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11. Determining What Is Part of the Business Combination Transaction
preexisting lawsuit between the acquirer and the acquiree, or a long-term supply contract
or an operating lease agreement between the acquirer and the acquiree with terms that are
favorable or unfavorable relative to market terms at the acquisition date, would not be
part of the business combination, and would therefore be accounted for in accordance
with other relevant GAAP.
11.004 In other instances, it may be less clear whether an amount relates to a transaction
or arrangement that is or is not part of the business combination, and a more detailed
analysis based on the above factors and other relevant information may be required in
making this determination.
11.005 ASC paragraphs 805-10-25-20 through 25-23 provide additional guidance in
assessing transactions entered into with an acquiree or by an acquiree on behalf of an
acquirer. See Other Payments to an Acquiree (or its Former Owners) That Are Not Part
of the Consideration Transferred beginning at Paragraph 11.066.
Example 11.0: Costs of Introducing New Processes to an Acquiree before
a Business Combination
Background
An entity (Acquirer) entered into an agreement to purchase a manufacturing operation
(Target) from a third party (Seller). Target meets the definition of a business under
ASC paragraph 805-10-55-3A. Seller agreed to incur costs to introduce certain new
processes into the facility to allow Acquirer to manufacture product not currently
manufactured by Target. If the new processes do not meet the specifications agreed by
the two parties, Acquirer can withdraw from the acquisition but must pay a penalty,
calculated by reference to the costs that Seller will incur to introduce the new
processes. The costs are business process reengineering expenses in the scope of ASC
Subtopic 720-45.
Acquirer considers the guidance in ASC paragraph 805-10-55-18 to determine whether
it should account for the new processes as part of the business combination.
(a) The reasons for the transaction – The introduction of the new processes into
the facility, although they could benefit both Target and Acquirer, are
primarily for the benefit of Acquirer and the combined entity to allow the
facility to manufacture a product not currently manufactured by Target.
(b) Who initiated the transaction – Acquirer initiated the transaction as part of
the negotiations of the business combination.
(c) The timing of the transaction – The parties agreed to introduce the new
processes during the negotiations for and in contemplation of the business
combination to provide future economic benefits to Acquirer and the
combined entity.
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11. Determining What Is Part of the Business Combination Transaction
Based on the analysis above, Acquirer concludes that introducing new processes just
before the business combination is primarily for its own benefit, and therefore not part
of consideration transferred in a business combination. As Target is incurring the
reengineering costs, Acquirer should record the expense and a payable (that will be
paid to either Seller or Target, depending on whether the transaction closes).
At closing, Acquirer applies the portion of the consideration paid to Seller representing
the reimbursement of business process reengineering expense as a reduction to the
payable it previously recorded. If the acquisition does not proceed, Acquirer will pay
the Target or Seller the penalty and reduce the payable.
PREEXISTING RELATIONSHIPS
ASC Paragraph 805-10-55-20
The acquirer and acquiree may have a relationship that existed before they
contemplated the business combination, referred to here as a preexisting
relationship. A preexisting relationship between the acquirer and acquiree may be
contractual (for example, vendor and customer or licensor and licensee) or
noncontractual (for example, plaintiff and defendant).
11.006 Preexisting relationships between the acquirer and the acquiree, including
contractual and noncontractual relationships, should be identified and assessed to
determine whether they have been effectively settled as a result of the business
combination transaction and should therefore be accounted for separately from the
business combination in accordance with other relevant GAAP. Because the acquirer
usually consolidates the acquiree following a business combination, preexisting
relationships are generally effectively settled as a result of the combination (i.e.,
following the business combination, such transactions are eliminated in the post-
combination consolidated financial statements). Prior to the issuance of ASC Topic 805,
EITF Issue No. 04-1, "Accounting for Preexisting Relationships between the Parties to a
Business Combination" provided guidance for the effective settlement of preexisting
relationships between the parties to a business combination. EITF 04-1 was nullified by
ASC Topic 805. However, the guidance in EITF 04-1 was generally incorporated into
ASC Topic 805.
SETTLEMENT OF PREEXISTING RELATIONSHIPS
ASC Paragraph 805-10-55-21
If the business combination in effect settles a preexisting relationship, the acquirer
recognizes a gain or loss, measured as follows:
a. For a preexisting noncontractual relationship, such as a lawsuit, fair value
b. For a preexisting contractual relationship, the lesser of the following:
1. The amount by which the contract is favorable or unfavorable from the
perspective of the acquirer when compared with pricing for current market
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11. Determining What Is Part of the Business Combination Transaction
transactions for the same or similar items. An unfavorable contract is a
contract that is unfavorable in terms of current market terms. It is not
necessarily a loss contract in which the unavoidable costs of meeting the
obligations under the contract exceed the economic benefits expected to be
received under it.
2. The amount of any stated settlement provisions in the contract available to
the counterparty to whom the contract is unfavorable. If this amount is less
than the amount in (b)(1), the difference is included as part of the business
combination accounting.
11.007 The measurement of the gain or loss arising from a preexisting relationship that is
effectively settled as the result of a business combination depends on whether that
preexisting relationship was contractual or noncontractual in nature. The difference
between the amount of the gain or loss measured in accordance with ASC paragraph 805-
10-55-21 and the amount previously recognized by the acquirer, if any, is recognized in
earnings at the acquisition date. See KPMG Handbook, Accounting for Income Taxes,
Section 6 The Tax Effects of Business Combinations for discussion of Recognizing the
Tax Effects of the Effective Settlement of a Preexisting Relationship in a Business
Combination.
Preexisting Noncontractual Relationships
11.008 An example of a preexisting noncontractual relationship between the acquirer and
acquiree would be a lawsuit relating to a noncontractual matter in which the two parties
had a relationship as plaintiff and defendant. If the lawsuit is effectively settled as a result
of a business combination, it would be measured at fair value, and the difference between
the amount measured and amounts previously recognized by the acquirer (in accordance
with applicable GAAP) would be recognized as a gain or loss at the acquisition date.
Example 11.1: Preexisting Noncontractual Relationship
ABC Corp. is the defendant in a lawsuit in which DEF Corp. is the plaintiff. ABC has
recognized a liability in the amount of $8 million related to this lawsuit in accordance
with ASC Topic 450, Contingencies. On January 1, 20Y0, ABC acquires DEF in a
business combination, and pays cash consideration of $100 million to DEF's
shareholders. ABC's acquisition of DEF effectively settles the lawsuit. ABC concludes
that the lawsuit should be evaluated as a preexisting noncontractual relationship. The fair
value of the lawsuit at January 1, 20Y0 is determined to be $5 million. ABC recognizes a
$3 million gain on the effective settlement of the lawsuit in earnings at the acquisition
date (the $8 million liability previously recognized under ASC Topic 450 less the $5
million fair value of the lawsuit at the acquisition date).
ABC records the following entry to recognize the acquisition of DEF and the effective
settlement of the lawsuit with DEF on the acquisition date:
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11. Determining What Is Part of the Business Combination Transaction
Debit
Credit
Net assets of DEF (including goodwill)
Litigation liability
$95 million
$8 million
Gain on settlement of litigation
Cash
$3 million
$100 million
In accounting for the acquisition, the consideration transferred to acquire DEF is $95
million (the $100 million paid to the shareholders of DEF less the $5 million recognized
in connection with the effective settlement of the lawsuit).
Preexisting Contractual Relationships
11.009 Examples of preexisting contractual relationships between the acquirer and
acquiree include a vendor and customer relationship, a lessor and lessee relationship, a
licensor and licensee relationship, or a lender and a borrower relationship. A preexisting
contractual relationship that is effectively settled as a result of a business combination is
measured at the lesser of the amount by which the contract is favorable or unfavorable
from the perspective of the acquirer, or the amount of any stated settlement provisions in
the contract available to the counterparty to whom the contract is unfavorable (zero for
contracts without a termination penalty). The difference between the amount so measured
and any amounts previously recognized by the acquirer (in accordance with applicable
GAAP) is recognized as a gain or loss at the acquisition date.
11.010 The following example, which is taken from ASC paragraphs 805-10-55-30
through 55-32, illustrates the accounting for the effective settlement of a supply contract
as a result of a business combination.
Example 11.2: Effective Settlement of a Supply Contract as a Result of a
Business Combination
AC purchases electronic components from TC under a five-year supply contract at
fixed rates. Currently, the fixed rates in the contract are higher than rates at which AC
could purchase similar electronic components from other suppliers. The supply
contract allows AC to terminate the contract before the end of the initial 5-year term by
paying a $6 million penalty. With 3 years remaining under the supply contract, AC
pays $50 million to acquire TC, which is the fair value of TC based on what other
market participants would be willing to pay.
Included in the total fair value of TC is $8 million related to the fair value of the supply
contract with AC. The $8 million represents a $3 million component that is "at-market"
because the pricing is comparable to pricing for current market transactions for the
same or similar items (selling effort, customer relationships, and so forth) and a $5
million component for pricing that is unfavorable to AC because it exceeds the price of
current market transactions for similar items. TC has no other identifiable assets or
liabilities related to the supply contract, and AC has not recognized any assets or
liabilities related to the supply contract before the business combination.
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11. Determining What Is Part of the Business Combination Transaction
In this example, AC recognizes a loss of $5 million (the lesser of the $6 million
settlement provision stated in the contract and the amount by which the contract is
unfavorable to the acquirer) separately from the business combination. The $3 million
at-market component of the contract is subsumed into goodwill in the acquisition
accounting. The consideration transferred by AC to acquire TC is $45 million (the $50
million paid less the $5 million attributable to the effective settlement of the
unfavorable supply contract). ASC paragraphs 805-10-55-30 through 55-32
11.011 The following example, which is taken from ASC paragraph 805-10-55-33,
illustrates the accounting for the effective settlement of a supply contract when the
acquirer had previously recognized a liability prior to the business combination.
Example 11.3: Effective Settlement of a Contract between the Acquirer
and Acquiree in Which the Acquirer Had Recognized a Liability before the
Business Combination
Whether AC had previously recognized an amount in its financial statements related to
a preexisting relationship will affect the amount recognized as a gain or loss for the
effective settlement of the relationship. In Example 11.2, GAAP might have required
AC to recognize a $6 million liability for the supply contract before the business
combination. In that situation, AC recognizes a $1 million settlement gain on the
contract in earnings at the acquisition date (the $5 million measured loss on the
contract less the $6 million loss previously recognized). In other words, AC has in
effect settled a recognized liability of $6 million for $5 million, resulting in a gain of
$1 million. ASC paragraph 805-10-55-33
11.012 The following example illustrates the accounting for the settlement of a license
agreement as a result of a business combination.
Example 11.4: Effective Settlement of a License Contract between the
Acquirer and Acquiree
ABC Corp. licensed spectrum capacity to DEF Corp. After the original agreement, the
market price of spectrum capacity changed substantially such that the contract is now
favorable to DEF. ABC acquired DEF while the spectrum license was favorable to DEF
and unfavorable to ABC. The fair value of DEF, including the favorable contract is $102,
whereas the fair value of DEF if the contract were instead at market value is $100.
ABC pays the same amount as a market participant to acquire DEF ($102), but as the
acquisition effectively settles the preexisting relationship, ABC would recognize a loss on
settlement of the preexisting relationship separate from the acquisition accounting.
Assuming ABC did not have a provision previously recognized for the unfavorable
contract, it would record the following:
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11. Determining What Is Part of the Business Combination Transaction
Net assets of DEF Corp.
Loss on settlement of contract
Cash
Debit
Credit
100
2
102
In contrast, if a market participant acquired DEF, the market participant would record an
asset of $2 related to the favorable contract (from DEF's perspective).
11.012a The following example illustrates the accounting for the settlement of accounts
receivable as a result of a business combination.
Example 11.4a: Effective Settlement of Accounts Receivable
Company A purchased all outstanding stock of Company B for $150. Company B was a
customer of Company A. At the acquisition date, Company A had a $10 accounts
receivable balance recorded from Company B and Company B had a corresponding
payable.
The accounts receivable and accounts payable balance between Company A and B was
effectively settled in the acquisition as the amount will eliminate in consolidation after
the acquisition. Therefore, Company A increased the consideration transferred by the
amount of the settled receivable to $160 ($150 cash + $10 receivable). There was no gain
or loss because there was no difference between the effective settlement amount and the
carrying amount of the receivable.
Effective Extinguishment of Debt between the Acquirer and the Acquiree
11.013 A business combination may result in the effective extinguishment of debt issued
by the acquirer. When a business combination results in the extinguishment of debt
issued by the acquirer to the acquiree, the acquirer should apply ASC Subtopic 470-50,
Debt - Modifications and Extinguishments, to account for the debt extinguishment. Any
settlement gain or loss that the acquirer recognizes in connection with the debt
extinguishment is recognized outside of the accounting for the acquisition.
11.014 If the preexisting relationship that is settled is debt issued by the acquiree to the
acquirer, then the acquirer applies the guidance in ASC paragraph 805-10-55-21(b)
related to the settlement of preexisting relationships in a business combination.
Reacquired Rights
11.015 An acquirer may have a preexisting relationship with an acquiree in the form of a
previously granted right such as a right to use intellectual property such as a brand or
trademark. As a result of a business combination, the acquirer essentially reacquires that
previously granted right. For example, an acquirer may have previously granted the
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acquiree the right to use the acquirer's trade name under a franchise agreement. ASC
Topic 805 specifies that rights reacquired by an acquirer in a business combination are
identifiable intangible assets that the acquirer recognizes separately from goodwill. See
Section 7 for guidance on the measurement of rights that are reacquired in a business
combination.
11.016 Additionally, if the terms of the reacquired right are favorable or unfavorable
relative to the terms of current market transactions for the same or similar items, the
acquirer recognizes a settlement gain or loss separate from the business combination,
measured using the guidance for settling preexisting relationships provided in ASC
paragraphs 805-20-25-14 through 25-15 and 805-10-55-21.
Example 11.5: Reacquired Rights with Off-Market Terms
Franchisor ABC Corp. acquires the business of operating Franchisee DEF Corp. In
connection with the acquisition, Franchisor ABC reacquires previously granted
franchise rights. Franchisor ABC pays $30 million to acquire Franchisee DEF. The
reacquired franchise right is valued at $3 million in accordance with the measurement
guidance in ASC Topic 805. The terms of the contract covering the rights are
unfavorable (from the perspective of the ABC, the acquirer) by $4 million relative to
the terms of current market transactions for the same or similar items, and the contract
does not include any cancellation or settlement provisions. The amount of the
identifiable net assets of Franchisee DEF, measured in accordance with ASC Topic
805, is $17 million (excluding the franchise right). Franchisor ABC records the
reacquisition of the franchise right and the acquisition of Franchisee DEF as follows:
Debit
Credit
Loss on reacquired franchisee right
Reacquired franchise right (intangible asset)
Identifiable net assets of Franchisee DEF
(excluding the reacquired franchise right)
Goodwill
$4 million
$3 million
$17 million
$6 million
Cash
$30 million
TRANSACTIONS THAT COMPENSATE EMPLOYEES OR
FORMER OWNERS OF THE ACQUIREE FOR SERVICES
11.017 Arrangements for Contingent Payments to Employees or Selling
Shareholders (Application of ASC paragraph 805-10-25-21(b)).
ASC Paragraph 805-10-55-24
Whether arrangements for contingent payments to employees or selling
shareholders are contingent consideration in the business combination or are
separate transactions depends on the nature of the arrangements. Understanding
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11. Determining What Is Part of the Business Combination Transaction
the reasons why the acquisition agreement includes a provision for contingent
payments, who initiated the arrangement, and when the parties entered into the
arrangement may be helpful in assessing the nature of the arrangement.
11.018 In a business combination an acquirer may enter into an arrangement for
contingent payments to employees or selling shareholders of the acquiree. The
accounting for such arrangements depends on whether they represent contingent
consideration issued in the business combination and are included in the accounting for
the acquisition, or are separate transactions and are accounted for in accordance with
other relevant GAAP.
• Contingent consideration issued in a business combination is usually an
obligation of the acquirer to transfer additional assets or equity interests to the
former owners of an acquiree as part of the exchange for control of the
acquiree if specified future events occur or conditions are met; however,
contingent consideration also may give the acquirer the right to the return of
previously transferred consideration if specified conditions are met or fail to
be met. (ASC Section 805-10-20) See the discussion of Contingent
Consideration in Section 6.
• Arrangements for contingent payments to employees or selling shareholders
that do not meet the definition of contingent consideration are not part of the
accounting for the business combination, and are therefore accounted for
separately in accordance with other relevant GAAP.
11.019 An understanding of the factors in ASC paragraph 805-10-55-18 (i.e., the reasons
why the acquisition agreement includes a provision for such payments, who initiated the
arrangement, and the timing of when the parties entered into the arrangement), as well as
the conditions that trigger payment of the consideration, may be helpful in assessing
whether the arrangement represents contingent consideration issued in the business
combination or is a transaction to be accounted for separately from the business
combination.
11.020 The following two examples, which are included as ASC paragraphs 805-10-55-
34 through 55-36, illustrate the consideration of ASC paragraph 805-10-55-18 factors on
the determination of whether an arrangement for contingent payments represents
contingent consideration issued in a business combination or is a transaction to be
accounted for separately from the business combination.
Example 11.6: Arrangement for Contingent Payment to an Employee
TC hired a candidate as its new CEO under a 10-year contract. The contract required
TC to pay the candidate $5 million if TC is acquired before the contract expires. AC
acquires TC eight years later. The CEO was still employed at the acquisition date and
will receive the additional payment under the existing contract.
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11. Determining What Is Part of the Business Combination Transaction
In this example, TC entered into the employment agreement before the negotiations of
the combination began, and the purpose of the agreement was to obtain the services of
CEO. Thus, there is no evidence that the agreement was arranged primarily to provide
benefits to AC or the combined entity. Therefore, the liability to pay $5 million is
included in the application of the acquisition method. ASC paragraphs 805-10-55-34
through 55-35
Example 11.7: Arrangement for Contingent Payment to an Employee at
the Suggestion of the Acquirer
In other circumstances, TC might enter into a similar agreement with CEO at the
suggestion of AC during the negotiations for the business combination. If so, the
primary purpose of the agreement might be to provide severance pay to CEO, and the
agreement may primarily benefit AC or the combined entity rather than TC or its
former owners. In that situation, AC accounts for the liability to pay CEO in its post-
combination financial statements separately from application of the acquisition
method. ASC paragraph 805-10-55-36
11.020a Contingent payments to employees may also be similar to sign on bonuses if
they are paid by the acquirer on the acquisition date without any requirement to perform
post-acquisition services. The following example illustrates the consideration of ASC
paragraph 805-10-55-18 in those arrangements.
Example 11.7a: Arrangement for Bonuses to Be Paid by the Acquirer to
Employees
Similar to Example 11.7, during the negotiations for the business combination, TC
enters into an agreement whereby employees that will become employed by AC will
receive cash bonuses as of the acquisition date if they continue to be employed on that
date. If the agreement was entered into in contemplation of the business combination, it
may primarily benefit AC or the combined entity rather than TC or its former owners.
In that situation, AC accounts for the liability to pay the employees in its post-
combination financial statements as an expense separately from application of the
acquisition method.
Example 11.7b: Rollover Equity not Compensatory
ABC LLC, 100% owned by ABC Parent LLC, acquires DEF LLC in a business
combination primarily by paying the shareholders of DEF cash consideration in
exchange for their ownership interests in DEF. As part of the overall transaction, ABC
Parent enters into a rollover agreement with the CEO of DEF to receive limited
liability company interests in ABC Parent for a portion of the CEO’s purchase
consideration based on her 5% ownership in DEF. That is, instead of receiving only
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11. Determining What Is Part of the Business Combination Transaction
cash consideration for her ownership in DEF, the CEO received a combination of cash
and LLC interests in ABC Parent that were commensurate with the fair value of the
cash consideration that other shareholders of DEF received for their ownership interest.
The CEO will become an employee of the combined entity. However, the rollover
agreement does not require any continuing involvement with the ongoing operations of
the company or vesting provisions tied to continuing employment.
The rollover equity is not considered compensatory due to the fact there is no required
continuing employment and considering the indicators in ASC paragraph 805-10-55-
25. The substance of the transaction is exchanging cash and equity for the CEO’s
previous ownership interest in DEF. Therefore, ABC should include the fair value of
the rollover equity issued by its parent company as part of the consideration
transferred.
ADDITIONAL INDICATORS FOR EVALUATING ARRANGEMENTS FOR
CONTINGENT PAYMENTS TO EMPLOYEES OR SELLING SHAREHOLDERS
ASC Paragraph 805-10-55-25
If it is not clear whether an arrangement for payments to employees or selling
shareholders is part of the exchange for the acquiree or is a transaction separate
from the business combination, the acquirer should consider the following
indicators:
a. Continuing employment. The terms of continuing employment by the selling
shareholders who become key employees may be an indicator of the substance of
a contingent consideration arrangement. The relevant terms of continuing
employment may be included in an employment agreement, acquisition
agreement, or some other document. A contingent consideration arrangement in
which the payments are automatically forfeited if employment terminates is
compensation for postcombination services. Arrangements in which the
contingent payments are not affected by employment termination may indicate
that the contingent payments are additional consideration rather than
compensation.
b. Duration of continuing employment. If the period of required employment
coincides with or is longer than the contingent payment period, that fact may
indicate that the contingent payments are, in substance, compensation.
c. Level of compensation. Situations in which employee compensation other than
the contingent payments is at a reasonable level in comparison to that of other key
employees in the combined entity may indicate that the contingent payments are
additional consideration rather than compensation.
d. Incremental payments to employees. If selling shareholders who do not become
employees receive lower contingent payments on a per-share basis than the
selling shareholders who become employees of the combined entity, that fact may
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indicate that the incremental amount of contingent payments to the selling
shareholders who become employees is compensation.
e. Number of shares owned. The relative number of shares owned by the selling
shareholders who remain as key employees may be an indicator of the substance
of the contingent consideration arrangement. For example, if the selling
shareholders who owned substantially all of the shares in the acquiree continue as
key employees, that fact may indicate that the arrangement is, in substance, a
profit-sharing arrangement intended to provide compensation for postcombination
services. Alternatively, if selling shareholders who continue as key employees
owned only a small number of shares of the acquiree and all selling shareholders
receive the same amount of contingent consideration on a per-share basis, that
fact may indicate that the contingent payments are additional consideration. The
preacquisition ownership interests held by parties related to selling shareholders
who continue as key employees, such as family members, also should be
considered.
f. Linkage to the valuation. If the initial consideration transferred at the
acquisition date is based on the low end of a range established in the valuation of
the acquiree and the contingent formula relates to that valuation approach, that
fact may suggest that the contingent payments are additional consideration.
Alternatively, if the contingent payment formula is consistent with prior profit-
sharing arrangements, that fact may suggest that the substance of the arrangement
is to provide compensation.
g. Formula for determining consideration. The formula used to determine the
contingent payment may be helpful in assessing the substance of the arrangement.
For example, if a contingent payment is determined on the basis of a multiple of
earnings, that might suggest that the obligation is contingent consideration in the
business combination and that the formula is intended to establish or verify the
fair value of the acquiree. In contrast, a contingent payment that is a specified
percentage of earnings might suggest that the obligation to employees is a profit-
sharing arrangement to compensate employees for services rendered.
h. Other agreements and issues. The terms of other arrangements with selling
shareholders (such as noncompete agreements, executory contracts, consulting
contracts, and property lease agreements) and the income tax treatment of
contingent payments may indicate that contingent payments are attributable to
something other than consideration for the acquiree. For example, in connection
with the acquisition, the acquirer might enter into a property lease arrangement
with a significant selling shareholder. If the lease payments specified in the lease
contract are significantly below market, some or all of the contingent payments to
the lessor (the selling shareholder) required by a separate arrangement for
contingent payments might be, in substance, payments for the use of the leased
property that the acquirer should recognize separately in its postcombination
financial statements. In contrast, if the lease contract specifies lease payments that
are consistent with market terms for the leased property, the arrangement for
contingent payments to the selling shareholder may be contingent consideration in
the business combination.
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ARRANGEMENTS FOR CONTINGENT PAYMENTS TO EMPLOYEES OR SELLING
SHAREHOLDERS THAT ARE FORFEITED IF EMPLOYMENT TERMINATES
11.021 ASC paragraph 805-10-55-25 states that a contingent consideration arrangement
in which the contingent payments are forfeited if employment terminates is compensation
for post-combination services. Before the effective date of ASC Topic 805, EITF Issue
No. 95-8, "Accounting for Contingent Consideration Paid to the Shareholders of an
Acquired Enterprise in a Purchase Business Combination," which was nullified by ASC
Topic 805, indicated that a contingent consideration arrangement in which payments are
automatically forfeited if employment terminates is a strong indicator that the
arrangement is compensation for post-combination service. Discussion with the FASB
staff indicated that the removal of the words strong indicator from the guidance in ASC
paragraph 805-10-55-25 was intentional and intended to require contingent consideration
arrangements in which payments are forfeited if employment terminates to be accounted
for as compensation for post-combination services. We believe that an arrangement in
which contingent payments to employees or selling shareholders are payable only if the
recipients remain in the employment of the combined entity following an acquisition,
represents compensation for post-combination service, even if evaluation of some (or
even all) of the other indicators in ASC paragraph 805-10-55-25 indicate that the
payments would otherwise be considered to be additional consideration transferred in
exchange for the acquiree. If a contingent consideration arrangement is not affected by
employment termination, the other indicators in ASC paragraph 805-10-55-25 should be
considered in determining whether the arrangement is part of the exchange for the
acquiree or a separate transaction. Before determining whether the arrangement is
contingent on the recipient's continued employment, the facts and circumstances of the
arrangement should be considered to determine whether one or multiple arrangements
exist. Examples 11.9 and 11.11 illustrate circumstances in which multiple arrangements
may exist.
11.021a In evaluating whether an arrangement should be recorded as compensation for
post-combination service, an acquirer should carefully consider any arrangements in
which a related party or a holder of an economic interest in the entity transfers, or
promises to transfer, cash or other assets to employees that remain in the employment of
the combined entity following the acquisition. Unless there is evidence that the transfer
was clearly for a purpose other than compensation for services to the combined entity (or
to incentivize their continued employment), those payments are recorded as
compensation. When the payments to employees are contingent on continued
employment, or the other indicators in ASC paragraph 805-10-55-25 indicate the
payments are compensatory, the acquirer would record post-combination compensation
expense.
11.021b As the concept of an economic interest is broadly applied, there may be
arrangements with continuing employees to which the acquirer is not a party that are
considered compensatory because it is not clear that the transfer was for a purpose other
than compensation. For example, a selling shareholder may enter into an arrangement
with its former employees that become employees of the combined entity to share a
portion of an earnout (contingent consideration) received from the acquirer. While the
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11. Determining What Is Part of the Business Combination Transaction
selling shareholder may enter into the arrangement to increase the likelihood that it will
receive the earnout, the promise to pay a portion of the earnout to employees who are
providing service to the combined entity indicates that the arrangement will benefit the
combined entity and therefore would be compensatory. As the transfer is not for a
purpose other than compensation, the acquirer recognizes the arrangement as
compensation for post-combination services.
Example 11.8: Stay Bonuses - Scenario 1
ABC Corp. acquires all of the outstanding equity shares of DEF Corp. in a business
combination. In connection with the acquisition, ABC offers bonuses (to be paid in
cash) to certain senior-level employees of DEF (the offerees). All of the offerees are
shareholders of DEF and, collectively, owned all of the outstanding shares of DEF
before its acquisition by ABC. The payment of bonuses to an individual offeree is
contingent on the offeree remaining employed by the combined entity for a two-year
period after the acquisition (i.e., an offeree's right to receive a bonus is forfeited in the
event the offeree does not remain with ABC during the two-year period). The amount
of the bonuses to be paid to each offeree will be determined based on a multiple of
earnings and the offeree's average annual salary during the two-year period following
the acquisition.
The bonuses represent compensation for post-combination services, as the right to a
bonus is forfeited if an offeree does not remain with the combined entity for the two-
year period following the acquisition. Evaluation of the other factors related to the
arrangement would not overcome this conclusion. Thus, the combined entity should
recognize compensation cost in a systematic and rational manner during the two-year
period the offerees' bonuses are earned.
Example 11.9: Stay Bonuses - Scenario 2
Assume the same facts as in Example 11.8, except that the arrangement provides for
contingent payments to each of the offerees (i.e., the former shareholders of DEF) as
follows:
(1) Regardless of whether an offeree remains employed by the combined entity,
the offeree is entitled to a contingent payment based on a multiple of
earnings during the two-year period following the acquisition and the
number of shares of DEF held by the offeree and acquired by ABC in the
acquisition.
(2) If an offeree remains employed by the combined entity for the two-year
period following the acquisition, the offeree is entitled to a contingent
payment equal to the higher of the amount determined under (1), or an
amount determined based on a multiple of earnings and the offeree's
average annual salary during the two-year period following the acquisition.
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11. Determining What Is Part of the Business Combination Transaction
In this example, each of the offerees are entitled to a contingent payment based on a
multiple of earnings and the number of DEF shares they held at the acquisition date
(i.e., as determined under (1) above), regardless of whether they remain with the
combined entity during the two-year post-combination period. Thus, because all
shareholders are participating in the arrangement in proportion to their ownership
interest in DEF before ABC acquires it, and because the contingent payment is not tied
to employment following the acquisition date, this portion is considered a separate
contingent consideration arrangement and constitutes part of the consideration
transferred by ABC in exchange for control of DEF. The contingent consideration
obligation is measured at its fair value at each reporting date until the contingency is
resolved. The changes in fair value are recognized in earnings (even if the arrangement
was a derivative, it is not subject to the requirements of ASC Topic 815, Derivatives
and Hedging, as it falls under the scope exclusion of ASC paragraphs 815-10-15-59
through 15-61, and therefore could not be designated as a hedging instrument).
See the discussion of Contingent Consideration in Section 6, Recognizing and
Measuring the Consideration Transferred.
If an offeree remains with the combined entity during the two-year post-combination
period, the offeree will be entitled to an additional payment if the amount determined
under (2) above (i.e., based on a multiple of earnings and the offeree's average annual
salary during the two-year period following the acquisition) exceeds the amount
determined under (1) above. Because any such additional payment is contingent on the
offeree's continuing employment with the combined entity, the additional payment for
this contingent consideration arrangement is compensation, is recognized by ABC for
post-combination services, and is therefore recognized by the combined entity as
compensation cost in a systematic and rational manner during the two-year period the
offeree's bonuses are earned.
Example 11.10: Shareholders/Executive Officers - Scenario 1
ABC Corp. purchases DEF, a small brokerage firm in which all of the shareholders are
executive officers of the firm. The terms of the purchase transaction provide for future
payments to the DEF shareholders based on future operating results and the continued
employment of the executive officers/shareholders for three years following the
acquisition. The potential additional payments to each of the shareholders based on
future operating results would be ratable based on their pre-combination shareholdings,
would exceed by a significant amount the consideration transferred to them at the
acquisition date and, if earned, will exceed by a significant amount what would
generally be considered to be reasonable compensation. However, if an executive
officer/shareholder does not remain with the entity for the full three-year period, that
individual's rights to future payments are forfeited.
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11. Determining What Is Part of the Business Combination Transaction
Because the future payments are contingent on the officers'/shareholders' continuing
employment with the combined entity following the acquisition, ABC should recognize
the future payments as compensation cost over the post-combination service period.
Example 11.11: Shareholders/Executive Officers - Scenario 2
ABC Corp. purchases Target from its four shareholders, consisting of Target's CEO
and spouse, and two unrelated parties. The Target CEO is the only shareholder who
will be employed by ABC. ABC offers each of the four shareholders additional cash
consideration contingent on the Target CEO's continuing employment for two years
subsequent to the business combination.
ABC should recognize the additional consideration payable to the Target CEO as
compensation cost during the two-year post-combination period, because the CEO's
right to the additional payment is conditioned on the CEO's continued employment
during that period. In addition, due to the nature of a spousal relationship unless it is
clear that the shares held by the spouse are unrelated to the spousal relationship, the
portion of the contingent consideration paid to the spouse is part of the CEO's
contingent consideration arrangement and is also compensation cost over the two-year
post-combination period.
The two unrelated shareholders do not have any future employment requirements and
therefore represent a separate arrangement. Accordingly, the fair value of the portion of
the additional consideration payable to the two unrelated shareholders is contingent on
the CEO remaining in the employment of ABC for the two-year post-combination, and
thus constitutes part of the consideration transferred by ABC in exchange for control of
Target. Thus, the contingent consideration is measured at fair value at the acquisition
date, and is included in the acquisition accounting. Additionally, because the
contingent consideration is payable in cash, it is classified as a liability and remeasured
to fair value each reporting period until the contingency is resolved. Changes in fair
value are recognized in earnings (unless the arrangement qualifies as a hedging
instrument for which ASC Topic 815 requires the changes to be initially recognized in
other comprehensive income, which seems to be an unlikely scenario in this example).
See discussion of Contingent Consideration in Section 6, Recognizing and Measuring
the Consideration Transferred.
We are aware of an alternative view whereby the payments to the unrelated
shareholders are also accounted for as compensation cost even though they have no
employment requirements. Under this view, if the payment is contingent on continued
employment of any employee, regardless of whether the employee is the recipient of
the payment, the contingent consideration is compensation cost.
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11. Determining What Is Part of the Business Combination Transaction
Example 11.12: Executive Officers - Double Trigger Awards
Scenario 1
ABC Corp. purchases Target. Target's COO has an employment agreement that
requires her to receive a $5 million cash severance payment upon a change in control
of the company and severance by the combined company. In this situation, if Target's
COO is terminated after the acquisition is consummated, the $5 million severance
payment would be treated as a post-combination expense, because the ultimate trigger
for the payment is the decision to terminate the former COO, which is made by the
acquirer after the acquisition date. This would be the case even if ABC plans, as part of
its acquisition decisions, to terminate Target's COO after the acquisition is
consummated.
Scenario 2
Contrary to Scenario 1, the double trigger in the COO's employment contract states that
she is entitled to the payment upon change in control and a Good Reason. Specifically,
the Good Reason clause states that she is entitled to the payment if after the
combination, her responsibilities in the combined company are significantly reduced
from her responsibilities before the acquisition. ABC plans to offer Target COO a
position as marketing director of the combined company in which she will report to
ABC's COO.
In our experience, entities normally view Scenario 2 as similar to Scenario 1 because
ABC has the ability to decide what the role and responsibilities of Target's former
COO will be after the acquisition and can, in effect, determine whether the second
trigger is invoked.
We are aware, however, that some Good Reason clauses may provide the acquirer with
no reasonable alternative and therefore would be the equivalent of a single trigger
provision (see Example 11.6). This alternative view would depend on the specific facts
and circumstances of the Good Reason clause and an SEC registrant may want to
consider consultation with the SEC staff before applying this approach.
Example 11.12a: Contingent Employee Compensation Paid to Selling
Shareholder if Forfeited by Employee
ABC Corp. acquires DEF Corp. on January 1, 20X8. As part of the acquisition, ABC
agrees to make cash payments to DEF employees over the next two years provided
they remain employed by the combined company. The payments are based on certain
EBITDA targets of the combined company and payable only if the employees are still
employed at the end of each year. Any amounts forfeited because an individual is no
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11. Determining What Is Part of the Business Combination Transaction
longer employed at the end of the year will instead be paid to the former shareholders
of DEF.
Although ABC will make the payments irrespective of whether the employees
complete the requisite service, ABC should account for the payments as compensation
expense in its post-combination financial statements. The nature of this arrangement is
to retain the employees and the payments should not be reflected as consideration
transferred to the seller.
TRANSITION SERVICE AGREEMENTS (TSAS)
11.021c An acquirer and seller commonly enter into TSAs in connection with a business
combination for the acquirer to obtain transitional support for a specified period of time
post-acquisition. TSAs typically provide the acquirer with a continuation of certain
operational tasks or functions, such as IT, accounting, and HR until the acquirer can
integrate the tasks or functions within its organization.
Generally, a TSA is a transaction separate from the business combination and is
accounted for in accordance with other relevant GAAP. The consideration transferred to
the seller should be allocated between the business combination and the TSA on a
relative fair value basis. If the TSA is priced at market rates for the services, it would
generally be accounted for based on the contractual amount. In contrast, if the seller
charges a below market rate for the transitional services, some portion of the
consideration transferred for the business combination likely would be allocated to the
TSA.
FORGIVENESS OF FULL-RECOURSE LOANS
11.022 Full-recourse loans previously granted to employees of an acquiree may be
forgiven in connection with a business combination. This could include loans granted to
employees in connection with the exercise of stock options, as well as loans granted for
other purposes. If it is not clear whether the forgiveness of the loans is part of the
exchange for the acquiree or is a transaction separate from the business combination, all
relevant facts and circumstances, including those identified in ASC paragraph 805-10-55-
25, should be considered in making the determination. For example:
•
If the loans were entered into prior to the commencement of negotiations for
the business combination, and the original terms of the notes require
forgiveness in the event of a change-in-control, such forgiveness would
generally not be accounted for by the acquirer as a transaction separate from
the business combination, as long as the forgiveness does not include any
post-combination service requirements and is not tied to another agreement
(entered into in connection with the loan agreement) that includes post-
combination service requirements.
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11. Determining What Is Part of the Business Combination Transaction
•
If the acquisition agreement includes a provision requiring forgiveness of
loans, a determination as to why the provision was included, as well as a
review of other arrangements entered into with the participating employees,
will be helpful in making the determination. For example, if the provision was
included at the request of the acquirer, and a termination agreement was also
entered into with the employee before the combination, the forgiveness might
constitute what is, in effect, a severance payment to the employee that should
be accounted for as a transaction separate from the business combination. An
acquirer cannot avoid the recognition of a severance cost that it would
otherwise expect to incur immediately following a business combination by
arranging for the acquiree to make the payment before the business
combination or by putting provisions in an acquisition agreement that
effectively provide for the payments.
11.023 In reviewing arrangements such as those discussed above, all arrangements with
the participating employees should be considered. For example, if two arrangements are
entered into at or about the same time, such as an arrangement providing for the
forgiveness of a loan with no service requirement, and a second arrangement that
includes a service requirement, consideration should be given as to whether the service
requirement included in the second arrangement should impact the determination of
whether the first arrangement is part of the exchange for the acquiree or is a transaction
separate from the business combination.
ACQUIRER SHARE-BASED PAYMENT AWARDS EXCHANGED
FOR AWARDS HELD BY THE GRANTEES OF THE ACQUIREE
11.023a This section has been updated for ASU 2018-07, Improvements to Nonemployee
Share-Based Payment Accounting, which requires companies to account for share-based
payment transactions with nonemployees in the same manner as share-based payment
transactions with employees, with differences remaining in the accounting for attribution
and an award-by-award election to use the contractual term as the expected term to value
nonemployee equity share options. The ASU also provides guidance on the accounting
for acquirer nonemployee share-based payment awards exchanged for awards held by
grantees of the acquiree. The ASU is effective for public business entities, certain not-
for-profit entities, and certain employee benefit plans for annual and interim periods in
fiscal years beginning after December 15, 2018. For all other entities, the ASU is
effective for annual periods in fiscal years beginning after December 15, 2019, and
interim periods in fiscal years beginning after December 15, 2020. Early adoption is
permitted, but no earlier than an entity’s adoption of Topic 606.
ASC Paragraph 805-30-30-9
An acquirer may exchange its share-based payment awards for awards held by
grantees of the acquiree. [ASC] Topic [805] refers to such awards as replacement
awards. Exchanges of share options or other share-based payment awards in
conjunction with a business combination are modifications of share-based
payment awards in accordance with [ASC] Topic 718. If the acquirer is obligated
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11. Determining What Is Part of the Business Combination Transaction
to replace the acquiree awards, either all or a portion of the fair-value-based
measure of the acquirer's replacement awards shall be included in measuring the
consideration transferred in the business combination. The acquirer is obligated to
replace the acquiree awards if the acquiree or its grantees have the ability to
enforce replacement. For example, for purposes of applying this requirement, the
acquirer is obligated to replace the acquiree's awards if replacement is required by
any of the following:
a. The terms of the acquisition agreement
b. The terms of the acquiree's awards
c. Applicable laws or regulations.
ASC Paragraph 805-30-30-10
In situations in which acquiree awards would expire as a consequence of a
business combination and the acquirer replaces those awards even though it is not
obligated to do so, all of the fair-value-based measure of the replacement awards
shall be recognized as compensation cost in the post-combination financial
statements. That is, none of the fair value-based measure of those awards shall be
included in measuring the consideration transferred in the business combination.
ASC Paragraph 805-30-30-11
To determine the portion of a replacement award that is part of the consideration
transferred for the acquiree, the acquirer shall measure both the replacement
awards granted by the acquirer and the acquiree awards as of the acquisition date
in accordance with [ASC] Topic 718. The portion of the fair-value-based measure
of the replacement award that is part of the consideration transferred in exchange
for the acquiree equals the portion of the acquiree award that is attributable to
precombination vesting.
ASC Paragraph 805-30-30-12
The acquirer shall attribute a portion of a replacement award to postcombination
vesting if it requires postcombination vesting, regardless of whether grantees had
rendered all of the service or delivered all of the goods required in exchange for
their acquiree awards before the acquisition date. The portion of a nonvested
replacement award attributable to post-combination vesting equals the total fair-
value-based measure of the replacement award less the amount attributed to
precombination vesting. Therefore, the acquirer shall attribute any excess of the
fair-value-based measure of the replacement award over the fair value of the
acquiree award to postcombination vesting.
ASC Paragraph 805-30-30-13
[ASC] paragraphs 805-30-55-6 through 55-13, 805-740-25-10 through 25-11,
805-740-45-5 through 45-6, and Example 2 (see [ASC] paragraph 805-30-55-17)
provide additional guidance and illustrations on distinguishing between the
portion of a replacement award that is attributable to precombination vesting,
which the acquirer includes in the consideration transferred in the business
combination, and the portion that is attributed to postcombination vesting, which
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11. Determining What Is Part of the Business Combination Transaction
the acquirer recognizes as compensation cost in its postcombination financial
statements.
11.024 An acquirer may issue share-based payment awards (replacement awards) to
employees or nonemployees of an acquiree in exchange for share options or other share-
based payment awards previously issued by the acquiree. Such exchanges are
modifications of share-based payment awards under ASC Topic 718, Compensation-
Stock Compensation.
ATTRIBUTION OF REPLACEMENT AWARDS TO CONSIDERATION
TRANSFERRED AND POST-COMBINATION VESTING
11.025 If the acquirer is obligated to replace the acquiree awards, all or a portion of the
fair-value-based measure of the acquirer's replacement awards is included in measuring
the consideration transferred in the business combination. If the acquirer is not obligated
to replace the acquiree awards, but chooses to do so voluntarily, all of the fair-value-
based measure of the replacement awards is recognized as compensation cost in the
acquirer's post-combination financial statements (and thus none of the fair-value-based
measure of the replacement awards is included in measuring the consideration transferred
in the business combination). Therefore, an acquirer would make a determination as to
whether it is obligated to replace the acquiree awards. This determination is based on
whether the acquiree or its grantees have the ability to enforce replacement. ASC
paragraph 805-30-30-9 indicates, for example, that the acquirer would be obligated to
issue replacement awards if replacement is required by:
a. The terms of the acquisition agreement
b. The terms of the acquiree's awards
c. Applicable laws or regulations.
MEASUREMENT
ASC Paragraph 805-20-30-21
The acquirer shall measure a liability or an equity instrument related to the
replacement of an acquiree's share-based payment awards with share-based
payment awards of the acquirer in accordance with the method in [ASC] Topic
718. [ASC] Topic [805] refers to the result of that method as the fair-value-based
measure of the award. Paragraphs 805-30-30-9 through 30-13 and 805-30-55-6
through 55-13 provide additional guidance.
11.026 Share-based payment awards are an exception to the fair value measurement
principle of ASC Topic 805. This exception requires that replacement awards be
measured at the acquisition date in accordance with ASC Topic 718, and refers to the
amounts so determined as the fair-value-based measure of the award. This applies
regardless of whether the fair-value-based measurement of a replacement award is
included in measuring the consideration transferred in a business combination, or is
recognized as compensation cost in the post-combination financial statements.
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11. Determining What Is Part of the Business Combination Transaction
11.027 Generally, share-based payments are measured using the fair-value-based
measurement method, and the discussion and examples in this Section focus on that
method. However, ASC Topic 718 permits nonpublic companies, as a policy election, to
use intrinsic value for liability-classified awards. Paragraph 718-30-30-2A allows a
nonpublic company that elected the fair-value-based measurement method to
subsequently change its accounting policy for measuring liability-classified awards to the
intrinsic value method without needing to evaluate whether the change in accounting
policy is preferable.
11.027a For additional discussion on the use of intrinsic value by nonpublic companies
for liability-classified awards, see KPMG Handbook, Share-Based Payment. For
example, an acquirer that is a nonpublic entity under ASC Topic 718 should measure
replacement awards using intrinsic value if the awards are liability-classified replacement
awards and that is the acquirer's ASC Topic 718 policy. Although this discussion focuses
on the fair-value-based method, the guidance in ASC Topic 805 and in this discussion
applies in situations where ASC Topic 718 permits the use of intrinsic value for the
replacement awards.
11.028 ASC Topic 805 sets two limits on the amount of the replacement awards' value
that can be included in the consideration transferred. The amount included in the
consideration transferred cannot exceed the fair-value-based measure of the replaced
awards. Any excess fair value is charged to post-combination expense (even if fully
vested at the acquisition date). In addition, the amount included in the consideration
transferred can only include the value attributable to pre-combination vesting.
ATTRIBUTION - EMPLOYEE AWARDS
11.029 If the acquiree's employees must render post-combination service under the
acquirer's replacement awards, the acquirer determines the portion of the award
attributable to pre-combination vesting (and therefore include in the measurement of the
consideration transferred in the business combination), and the portion of the award
attributable to post-combination vesting (and therefore recognized as compensation cost
in the post-combination financial statements). Entities should do so following the
framework described below, rather than assuming that vested awards are part of the
consideration transferred and unvested awards are allocated between pre-combination
vesting and post-combination vesting. The approach is the same, regardless of whether
the replacement award is classified as a liability or equity.
11.030 The attribution of a replacement award (between pre-combination and post-
combination vesting) is a multi-step process:
(1) The first step requires the measurement at the acquisition date, in accordance
with the fair-value-based measurement method (unless the calculated value
method or intrinsic value method is appropriate in accordance with ASC
Topic 718), of:
(a) The acquiree award, and
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11. Determining What Is Part of the Business Combination Transaction
(b) The replacement award.
(2) The next step requires the determination of the following:
(a) The requisite service period for the acquiree award (the original service
period)*
(b) The portion of the requisite service period that was completed prior to the
acquisition date*
(c) The post-combination requisite service period, if any, for the replacement
award*
(d) The total service period (i.e., the sum of 2(b) and 2(c)).
* As specified in ASC Topic 718, the requisite service period includes
explicit, implicit, or derived service periods during which employees are
required to provide service in exchange for the award.
(3) The portion of the replacement award attributable to pre-combination vesting
is then calculated by multiplying the fair-value-based measure of the acquiree
award (determined in 1(a)) by the ratio of the pre-combination vesting period
(determined in 2(b)) to the greater of the total service period (determined in
2(d)) or the original service period (determined in 2(a)).
(4) The portion of the replacement award attributable to post-combination vesting
is then calculated as the difference between the fair-value-based measure of
the replacement award (determined in 1(b)) and the amount attributed to pre-
combination vesting (determined in 3).
11.031 This process is illustrated in Examples throughout this Section.
11.032 The above process results in the following:
• Even if an acquiree award is fully vested at the time of a business
combination, a portion of the replacement award is allocated to post-
combination vesting if the acquiree's employee is required to render service in
the post-combination period.
• The acquirer measures both the replacement award given to employees by the
acquirer as well as the original acquiree award as of the acquisition date. The
excess value of the replacement award over the measure of the acquiree award
is attributed to post-combination vesting and is not part of the consideration
transferred for the acquiree, even if all services have been rendered as of the
acquisition date. If the acquirer does not require the acquiree's employees to
perform additional services after the acquisition date, the excess value is
recognized immediately as compensation cost in the post-combination
financial statements of the combined entity. If additional services are required,
then the compensation cost is recognized in the post-combination financial
statements under ASC Topic 718.
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11. Determining What Is Part of the Business Combination Transaction
11.033 The following examples, which are based on the examples in ASC paragraphs
805-30-55-17 through 55-24, illustrate the concepts discussed above. Example 11.17c
illustrates the difference in accounting for a replacement award if the acquirer elects to
estimate forfeitures rather than accounting for forfeitures as they occur under the policy
election in ASC paragraph 718-10-35-3.
Example 11.13: Acquirer Replacement Awards That Require No Post-
combination Vesting Exchanged for Acquiree Awards for Which
Employees Have Rendered the Required Services as of the Acquisition
Date
AC issues replacement awards of $110 (fair-value-based measure) at the acquisition
date for TC awards of $100 (fair-value-based measure) at the acquisition date. No post-
combination vesting is required for the replacement awards, and TC's employees had
rendered all of the required service for the acquiree awards as of the acquisition date.
The amount attributable to pre-combination vesting is the fair-value-based measure of
TC's awards ($100) at the acquisition date; that amount is included in the consideration
transferred in the business combination. The amount attributable to post-combination
vesting is $10, which is the difference between the total value of the replacement
awards ($110) and the portion attributable to pre-combination vesting ($100). Because
no post-combination vesting is required for the replacement awards, AC immediately
recognizes $10 as compensation cost in its post-combination financial statements. ASC
paragraphs 805-30-55-18 and 55-19
Example 11.14: Recording Replacement Awards that Provide Additional
Fair Value if Post-combination Vesting Is Rendered
ABC Corp. acquires DEF Corp. At the acquisition date, the share based awards held by
DEF Corp. employees were fully vested and therefore no additional service is required
of the employees. The terms of the business combination require ABC to provide
replacement awards for the DEF awards. The replacement awards are fully vested but
subject to a 7-year transferability restriction. Earlier transfer is permitted if the
employee remains continuously employed for two years during the post-combination
period.
The fair value of the DEF awards is $50,000 at the acquisition date. The replacement
awards subject to the 7-year transferability restriction have a fair value of $150,000 at
the acquisition date. If the post-combination vesting requirement of 2 years is
completed, the replacement awards have a fair value of $166,000 at acquisition. ABC
Management expects that all of the employees will complete the 2-year post-
combination vesting.
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11. Determining What Is Part of the Business Combination Transaction
It is appropriate to analogize to the guidance on a tandem award as discussed in ASC
paragraph 718-10-55-116. A tandem award is an award with 2 or more components in
which the exercise of one award cancels out the other.
Under ASC Section 805-30-55, ABC includes $50,000 (the fair value-based measure
of the acquiree awards) in consideration transferred in the acquisition of DEF. The
remaining fair value-based measure of the replacement awards ($150,000 - $50,000) is
recognized as compensation cost by ABC immediately following the consummation of
the business combination because the employees are not required to perform additional
service. The incremental fair value of $16,000 ($166,000 - $150,000) associated with
the 2-year post combination service period that would eliminate the 7-year
transferability restriction is recorded as compensation cost over the 2-year service
period.
If ABC determines that employees are not expected to complete the 2-year service
period, ABC would cease recognizing the compensation cost for the incremental fair
value of the award and reverse any portion of compensation cost already recorded,
similar to a forfeiture.
Example 11.15: Acquirer Replacement Awards That Require Post-
combination Vesting Exchanged for Acquiree Awards for Which
Employees Have Rendered the Requisite Service as of the Acquisition
Date
AC exchanges replacement awards that require one year of post-combination vesting
for share-based payment awards of TC for which employees had completed the
requisite service period before the business combination. The fair-value-based measure
of both awards is $100 at the acquisition date. When originally granted, TC's awards
had a requisite service period of 4 years. As of the acquisition date, the TC employees
holding unexercised awards had rendered a total of 7 years of service since the grant
date. Even though TC employees had already rendered all of the requisite service, AC
attributes a portion of the replacement award to post-combination vesting in
accordance with ASC paragraphs 805-30-30-12 and 30-13 because the replacement
awards require one year of post-combination vesting. The total service period is 5
years--the requisite service period for the original acquiree award completed before the
acquisition date (4 years) plus the requisite service period for the replacement award
(one year). Note that the total service provided prior to the acquisition (7 years) is not
relevant to this computation. The portion attributable to pre-combination vesting equals
the fair-value-based measure of the acquiree award ($100) multiplied by the ratio of the
pre-combination vesting period (4 years) to the total service period (5 years). Thus, $80
($100 × 4 ÷ 5 years) is attributed to pre-combination vesting and therefore included in
the consideration transferred in the business combination. The remaining $20 is
attributed to post-combination vesting and therefore is recognized as compensation
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11. Determining What Is Part of the Business Combination Transaction
cost in AC's post-combination financial statements in accordance with ASC Topic 718.
ASC paragraph 805-30-55-20
Example 11.16: Acquirer Replacement Awards That Require Post-
combination Vesting Exchanged for Acquiree Awards for Which
Employees Have Not Rendered All of the Requisite Service as of the
Acquisition Date
AC exchanges replacement awards that require one year of post-combination vesting
for share-based payment awards of TC for which employees had not yet rendered all of
the required services as of the acquisition date. The fair-value-based measure of both
awards is $100 at the acquisition date. When originally granted, the awards of TC had a
requisite service period of 4 years. As of the acquisition date, the TC employees had
rendered 2 years' service, and they would have been required to render 2 additional
years of service after the acquisition date for their awards to vest. Accordingly, only a
portion of the TC awards is attributable to pre-combination vesting.
The replacement awards require only one year of post-combination vesting. Because
employees have already rendered 2 years of service, the total requisite service period is
3 years. The portion attributable to pre-combination vesting equals the fair-value-based
measure of the acquiree award ($100) multiplied by the ratio of the pre-combination
vesting period (2 years) to the greater of the total service period (3 years) or the
original service period of TC's award (4 years). Thus, $50 ($100 × 2 ÷ 4 years) is
attributable to pre-combination vesting and therefore included in the consideration
transferred for the acquiree. The remaining $50 is attributable to post-combination
vesting and is therefore recognized as compensation cost over the remaining one year
vesting period in AC's post-combination financial statements. ASC paragraphs 805-30-
55-21 and 55-22
Example 11.17: Acquirer Replacement Awards for Which No Post-
combination Vesting Is Required Exchanged for Acquiree Awards for
Which Employees Have Not Rendered All of the Requisite Service as of
the Acquisition Date
Assume the same facts as in Example 11.16, except that AC exchanges replacement
awards that require no post-combination vesting for share-based payment awards of TC
for which employees had not yet rendered all of the requisite service as of the
acquisition date. The terms of the replaced TC awards did not eliminate any remaining
requisite service period upon a change in control. (If the TC awards had included a
provision that eliminated any remaining requisite service period upon a change in
control, the guidance in Example 11.13 would apply.) The fair-value-based measure of
both awards is $100. Because employees have already rendered 2 years of service and
the replacement awards do not require any post-combination vesting, the total service
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11. Determining What Is Part of the Business Combination Transaction
period is 2 years. The portion of the fair-value-based measure of the replacement
awards attributable to pre-combination vesting equals the fair-value-based measure of
the acquiree award ($100) multiplied by the ratio of the pre-combination vesting period
(2 years) to the greater of the total service period (2 years) or the original service
period of TC's award (4 years). Thus, $50 ($100 × 2 ÷ 4 years) is attributable to pre-
combination vesting and therefore included in the consideration transferred in the
business combination, and the excess of the fair value-based measure of the
replacement award ($100) over the $50 attributed to the consideration transferred, or
$50, is attributed to post-combination vesting. Because no post-combination vesting is
required following the acquisition, the $50 attributed to post-combination vesting is
recognized immediately as compensation cost in the post-combination financial
statements. ASC paragraphs 805-30-55-23 and 55-24
(PRE-ASU 2018-07) ATTRIBUTION - NONEMPLOYEES
11.033a The fair value of share-based awards granted by the acquiring entity to
nonemployees generally should be treated as part of the consideration transferred using
the same approach used for replacement awards issued to the acquired entity’s
employees. This will apply whether the acquired entity issued awards to nonemployee
service providers or to employees of another entity as a result of a spin-off. For additional
information on ASU 2018-07, see Paragraph 11.023a.
Example 11.17a: Share Options Granted to Nonemployees in a Business
Combination
Background
On January 1, 20X4, ABC Corp. issues share options to Company A, a third-party
service provider, in connection with a marketing agreement where Company A
provides marketing services to ABC. The share options vest on January 1, 20X8. On
January 1, 20X5, ABC is acquired by XYZ Corp.
Q. If XYZ issues share options in exchange for the unvested share options held by
employees and nonemployees of ABC, how should XYZ account for the replacement
share options that it issues to nonemployees (i.e., Company A) of ABC?
A. XYZ should account for the fair value of the share options that it issues to
nonemployees as part of the consideration transferred using the same approach for
attributing the replacement award to pre- and post-combination vesting, to the extent
that the fair value of the new share options does not exceed the fair value of the share
options in ABC surrendered in the exchange. Therefore, XYZ would include 25% (i.e.,
one of four years vested) of the fair value of ABC’s share options (measured at the
acquisition date) in determining the consideration transferred. If the share options
issued by XYZ to nonemployees (i.e., Company A) are subsequently forfeited, no
adjustment should be made to the consideration transferred.
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11. Determining What Is Part of the Business Combination Transaction
(POST-ASU 2018-07) ATTRIBUTION - NONEMPLOYEES
ASC Paragraph 805-30-55-9A
The portion of a nonemployee replacement award attributable to precombination
vesting is based on the fair-value based measure of the acquiree award multiplied
by the percentage that would have been recognized had the grantor paid cash for
the goods or services instead of paying with a nonemployee award. For this
calculation, the percentage that would have been recognized is the lower of:
a. The percentage that would have been recognized calculated on the basis of
the original vesting requirements of the nonemployee award
b. The percentage that would have been recognized calculated on the basis of
the effective vesting requirements. Effective vesting requirements are equal to
the services or goods provided before the acquisition date plus any additional
postcombination services or goods required by the replacement award.
11.033b ASU 2018-07 modifies the accounting treatment for unvested share-based
awards granted to nonemployees in a business combination, which were treated similar to
share-based payments granted to employees prior to the adoption. The new ASU added a
notion of effective vesting requirements, which are the goods or services provided before
the acquisition date plus the additional goods or services required by the replacement
award. If the effective vesting period is longer than the vesting period of the original
award, the amount attributed to pre-combination vesting could be lower than it would be
before adoption of ASU 2018-07. The portion of the compensation expense attributed to
postcombination vesting should be recognized in the same manner as if the grantor had
paid cash for the goods or services, consistent with the attribution of other nonemployee
share-based payment awards.
Example 11.17b: Acquirer Replacement Awards That Require Post-
combination Vesting Exchanged for Acquiree Awards for Which
Nonemployees Have Not Delivered all of the Goods or Services as of the
Acquisition Date1
In a business combination, AC (the acquirer) exchanges replacement awards that
require the delivery of 10 widgets postcombination for share-based payment awards of
TC (the acquiree) for which the grantee had not met the necessary vesting condition to
deliver 40 widgets before the business combination. The fair-value-based measure of
both awards is $100 at the acquisition date. As of the acquisition date, TC grantee has
delivered 20 widgets, and would have been required to deliver an additional 20 widgets
after the acquisition date for its awards to vest. However, AC concluded that it needed
only 10 additional widgets after the acquisition date, rather than the 20 remaining
under the original contract. Only a portion of TC's awards is attributable to
precombination vesting.
The portion attributable to precombination vesting equals the fair-value-based measure
of the acquiree award ($100) multiplied by the percentage that would have been
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11. Determining What Is Part of the Business Combination Transaction
recognized on the award. The percentage that would have been recognized is the lower
of the percentage that would have been recognized on the basis of the original vesting
requirements and the percentage that would have been recognized on the basis of the
effective vesting requirements. The percentage that would have been recognized on the
basis of the original vesting requirements equals 50%, which is calculated as 20
widgets delivered divided by 40 widgets required to be delivered. The percentage that
would have been recognized on the basis of the effective vesting requirements equals
66.67%, which is calculated as 20 widgets delivered divided by 30 widgets (the sum of
20 widgets delivered plus 10 widgets required postcombination). Thus, $50 ($100 ×
50%) is attributed to precombination vesting and is included in the consideration
transferred in the business combination. The remaining $50 is attributed to the
postcombination vesting and is recognized as compensation cost in AC’s
postcombination financial statements. ASC paragraphs 805-30-55-32 and 55-33
ACCOUNTING FOR FORFEITURES OF REPLACEMENT AWARDS
IN A BUSINESS COMBINATION
11.033c Regardless of its accounting policy election for forfeitures in its ongoing
accounting for employee or nonemployee share-based payment awards under ASC
paragraphs 718-10-35-3 and 718-10-35-1D, respectively, the acquirer will reduce the
value of the nonvested replacement awards to reflect the estimate of the awards expected
to vest. As a result, the value of the nonvested replacement awards attributable to
precombination vesting and included in consideration transferred reflects the acquirer's
estimate at the acquisition date of the number of replacement awards not expected to vest.
That is, the portion of a nonvested replacement award included in consideration
transferred reflects the acquirer’s estimate of the number of replacement awards for
which the service is expected to be rendered (or goods are expected to be delivered).
11.033d However, the acquirer’s accounting policy election for forfeitures will affect the
accounting for postcombination compensation cost as follows:
• An acquirer that has a policy to estimate forfeitures of awards also will reduce
the number of replacement awards attributable to postcombination vesting for
its estimate at the acquisition date of the number of replacement awards not
expected to vest. Changes in the acquirer’s forfeiture estimate for replacement
awards attributable to both the pre- and postcombination vesting periods are
reflected in compensation cost for the periods in which the changes in
estimates occur rather than as adjustments to the consideration transferred.
• An acquirer that has a policy to recognize forfeitures of awards as they occur
will attribute the amount to consideration transferred in the same way (i.e.,
using an estimate of forfeitures). It will then gross up the portion allocated to
postcombination vesting assuming that no forfeitures will occur and recognize
this amount as compensation cost over the postcombination vesting period.
Any forfeitures of replacement awards are reflected as a reduction in
compensation cost in the periods in which the forfeitures occur. As is the case
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11. Determining What Is Part of the Business Combination Transaction
when forfeitures are estimated, the effect of actual forfeitures does not change
the value of the replacement awards included in the consideration transferred.
Example 11.17c: Effect of Acquirer’s Forfeiture Accounting Policy on
Post-Acquisition Accounting for Replacement Share-Based Payment
Awards
AC acquires TC. AC is obligated to replace share-based payment awards of TC. The
replacement awards require one year of postcombination vesting by TC employees for
the awards to vest. TC employees completed 4 of the 5 years of the requisite service
period before the date of the business combination. The fair value of TC’s awards and
the replacement awards is $100 on the acquisition date. At the acquisition date, AC
estimates that the requisite service period will be rendered for 90% of the awards, and
10% of the awards will be forfeited before the end of the requisite service period.
If AC elects to estimate forfeitures
The amount attributable to precombination vesting and included in consideration
transferred is $72 [$100 acquisition date fair value of TC’s replaced award × (1 - 10%
forfeiture rate) × (4 years’ precombination vesting ÷ 5-year service period)].
The amount attributable to postcombination vesting and recorded as postcombination
compensation cost is $18 [$100 acquisition date fair value of AC’s replacement award
× (1 - 10% forfeiture rate) - $72 included in consideration transferred]. The
postcombination compensation cost is recognized over the remaining one-year service
period. Any changes in the 10% forfeiture estimate are reflected as an adjustment to
compensation cost as those changes in estimate occur and ultimately trued-up to the
actual number of awards that vest. If, for example, the actual forfeiture rate is 5%, AC
will recognize compensation cost of $23 ($100 acquisition date fair value of AC’s
replacement award × (1 - 5% actual forfeiture rate) - $72 (allocated to consideration
transferred).
If AC elects to recognize forfeitures as they occur
The amount attributable to precombination vesting and included in consideration
transferred is $72 (same as if AC’s accounting policy is to estimate forfeitures).
The initial amount attributable to postcombination vesting and recorded as
postcombination compensation cost is $28 ($100 acquisition date fair value of its
replacement award - $72 included in consideration transferred). The postcombination
compensation cost is recognized over the remaining one-year requisite service period.
The effects of any forfeitures are reflected as a reduction to compensation cost as they
occur. If the 10% forfeiture estimate ultimately is accurate and all the forfeitures occur
in the last quarter before vesting, the compensation cost recognized each quarter after
the business combination will be: 1st Q: $7, 2nd Q: $7, 3rd Q: $7 (in each case the
amount recognized as compensation cost is $28 ÷ 4 quarters), 4th Q: -$3 (actual value
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11. Determining What Is Part of the Business Combination Transaction
vested of $90 - consideration transferred of $72 - compensation cost previously
recognized of $21).
AWARDS WITH GRADED VESTING - EMPLOYEE AWARDS
11.034 If the acquirer issues a replacement award that has a graded vesting schedule, we
believe that ASC paragraphs 805-30-55-11 and 55-12 require the acquirer to follow its
own policy with respect to straight-line or accelerated attribution for awards with graded
vesting features, regardless of the policies of the target entity. The acquirer does not carry
over the acquiree's attribution election for these types of awards. The result may be that
some compensation cost is never recognized by either party or that some compensation
cost is recognized by both parties.
Example 11.18: Graded Vesting Replacement Awards
ABC Corp. acquires DEF Corp. on January 1, 20X9. ABC issues a replacement award of
100 share options with a fair value of $1,000 to replace share options with a fair value on
the acquisition date of $1,000 held by DEF employees.
The vesting for the original DEF awards is graded, with 25% vesting each year over 4
years. At the acquisition date, DEF's employees have provided two years of service. DEF's
share option plan does not contain a change of control provision. However, the terms of
the business combination require ABC to issue to DEF employees a replacement award
with identical vesting provisions. Both ABC and DEF's attribution policy is to recognize
compensation cost on a graded vesting schedule. DEF’s accounting policy is to estimate
forfeitures expected to occur. Assume estimated forfeitures are zero. The amount of the
award attributed to pre-combination and post-combination vesting is determined as
follows:
The total service period is determined on a tranche-by-tranche basis based on ABC's
policy of using accelerated attribution.
Tranche 1
Tranche 2
Tranche 3
Tranche 4
ABC's Awards Vesting Schedule
25.00%
12.50%
8.33%
6.25%
52.08%
12.50%
8.34%
6.25%
27.09%
8.33%
6.25%
14.58%
6.25%
6.25%
Amount attributed to pre-combination vesting
$1,0001 × 79.17%2 (52.08% + 27.09%) = $792
1 Fair-value-based measure of DEF's award immediately before the acquisition.
2 Service rendered as of 1/1/20X9 based on ABC's attribution election.
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11. Determining What Is Part of the Business Combination Transaction
Amount attributed to post-combination vesting
$1,0003 - $7924 = $208
3 Fair-value-based measure of ABC's award immediately before the acquisition.
4 Amount attributable to pre-combination vesting
Amount of compensation expense recognized in the post-combination period
First post-combination year: $1,000 × 14.58% = $146
Second post-combination year: $1,000 × 6.25% = $ 62
The measurement of pre-combination vesting is based on ABC's policy of using the
accelerated attribution methodology. In this case, both parties used that method. However,
the answer would be the same even if DEF had elected to use the straight-line
methodology (i.e., as discussed above, we believe ASC paragraphs 805-30-55-11 and 55-
12 require the acquirer to follow its own policy with respect to attribution of awards with
graded vesting features). Additionally, the calculation uses the entire award as the unit of
measure. As a result, the attribution of the $208 allocated to the remaining tranches is
based on the total service period associated with those tranches and is allocated and
measured as if the acquirer had been accounting for them from inception. In many cases
(and in this example), entities would get the same answer regardless of whether the unit of
account is the entire award or each tranche, because the fair value and the requisite service
period are the same before and after the transaction. However, differences would arise if
one or both of them were different.
Example 11.18a: Graded Vesting Replacement Awards – Part II
ABC Corp. acquires DEF Corp. on January 1, 20X8. ABC issues a replacement award of
100 share options with a fair value of $1,000 to replace share options with a fair value on
the acquisition date of $1,000 held by DEF employees.
The vesting for the original DEF awards is graded, with 33.3% vesting each year over
three years. At the acquisition date, DEF’s employees have provided two years of service.
DEF’s share option plan does not contain a change of control provision. However, the
terms of the business combination require ABC to issue to DEF employees a replacement
award with a four-year graded vesting schedule. ABC’s attribution policy is to recognize
compensation cost on a straight-line basis, subject to a floor. DEF’s accounting policy is
to estimate forfeitures expected to occur. Assume estimated forfeitures are zero.
ABC’s legal counsel has interpreted the contract terms to mean that any previously
vested tranches (67 shares or 66.7%) remain vested, the 20X8 tranche will vest at its full
25% amount (i.e., 25 share options for a cumulative amount vested of 91.7%) and then
the 20X9 tranche will be the remaining 8 share options (i.e., 8.3%). The graded vesting
schedule for the ABC replacement awards and the DEF original awards is:
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11. Determining What Is Part of the Business Combination Transaction
ABC’s Replacement Awards Graded Vesting Schedule
20X6
20X7
20X8
Straight-line without floor
Straight-line with floor
25%
33.3%
25%
33.3%
25%
25%
20X9
25%
8.3%
DEF’s Original Awards Graded Vesting Schedule
20X6
20X7
20X8
33.3%
33.3%
33.3%
Although ABC’s policy is to recognize compensation cost on a straight-line basis for the
entire award, the replacement award has a front-loaded vesting schedule that is subject to
the floor. ASC paragraph 718-10-35-8 states that the amount of compensation cost
recognized at any date must at least equal the portion of the grant-date fair value of the
award that has vested at that date.
Amount attributed to precombination vesting
$1,0001 × 66.7%2 = $667
1 Fair-value-based measure of DEF’s award immediately before the acquisition.
2 Amount attributed to pre-combination vesting in accordance with acquirer’s policy for the greater of
straight-line attribution (2 of 4 years' service provided) or the floor (66.7% vested).
Amount attributed to postcombination vesting
$1,0003 - $6674 = $333
3 Fair-value-based measure of ABC’s award immediately before the acquisition.
4 Amount attributable to precombination service.
Amount of compensation cost recognized in the postcombination period
Postcombination compensation cost year 20X8 (based on the floor): $1,000 × 25.00% =
$250
Postcombination compensation cost year 20X9: $1,000 × 8.3% = $83
The compensation cost to be recognized in the postcombination period will be recognized
on a straight-line basis but subject to the floor. Given the front-loaded vesting schedule of
the replacement awards, this will result in 25% in 20X8 and 8.3% in 20X9.
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11. Determining What Is Part of the Business Combination Transaction
SETTLEMENT OF SHARE-BASED AWARDS
11.034a In some transactions, share-based payment awards of the acquired entity are
settled as part of the business combination. In the acquirer’s financial statements, the
accounting for the settlement of awards in the business combination will be the same
whether the acquirer settles the awards as part of the business combination or the
acquired entity settles the awards on the instructions of the acquiring entity and the
acquiring entity reimburses the acquired entity for the cost of the settlement. An
acquiring entity reimbursement sometimes is a direct addition to the consideration
transferred and sometimes is indirect – such as through the mechanics of a working
capital calculation specified in the acquisition agreement. In any of these instances, the
acquiring entity should follow the accounting guidance in Paragraphs 11.025 and 11.030
to determine the portion of the amount paid that will be accounted for as additional
consideration and the portion of the amount paid that will be accounted for as
postcombination compensation cost.
11.035 If an acquirer is permitted to settle acquiree awards that are not fully vested by
either issuing a replacement award with identical vesting provisions or by settling the
awards in cash, and the acquirer elects to settle the awards in cash, any compensation cost
attributed to post-combination vesting would be immediately recognized by the acquirer
in its post-combination financial statements. In this scenario, the acquirer has effectively
released the award holders from their post-combination vesting requirements.
Alternatively, the acquirer may replace the share-based payment awards with a cash
settlement that is paid only on the completion of future service. The portion of the
payment attributable to future services as determined using the guidance in Paragraphs
11.025 and 11.030 would be recognized as future services are performed under ASC
Topic 710, Compensation-General.
Example 11.19: Acquirer Cash Settles an Acquiree's Award
ABC Corp. acquires DEF Corp. on January 1, 20X9. ABC pays DEF's employees
$1,100 in cash to replace share options held by DEF employees with a fair value on the
acquisition date of $1,000.
The original service period for DEF awards is 4 years, of which 2 years have been
completed at the acquisition date. The original vesting for DEF's awards is graded with
25% vesting each year. DEF's share option plan does not contain any change-of-control
provisions. However, the terms of the business combination require ABC to either
issue to DEF employees replacement awards with identical vesting provisions or, at
ABC's election, a cash payment equal to 110% of the fair value of the award ($1,000 ×
110%, or $1,100) at the acquisition date. ABC elected to settle the awards in cash.
ABC's attribution policy based on ASC Topic 718 is to recognize the compensation
cost ratably (straight-line method) over the service period of the longest vesting
tranche. DEF's attribution policy is to recognize compensation cost on a graded vesting
schedule and, therefore, as of the acquisition date DEF has attributed 79.17% (Example
11.18 illustrates the calculation of this percentage) of the compensation cost associated
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11. Determining What Is Part of the Business Combination Transaction
with the DEF awards to pre-combination vesting. DEF’s accounting policy is to
estimate forfeitures expected to occur. Assume estimated forfeitures are zero. The
amount of the award attributed to pre-combination and post-combination vesting is
determined as follows:
Amount attributed to pre-combination vesting
$1,0001 × 50% (2 years / 4 years) 2 = $500
1 Fair-value-based measure of DEF's award immediately before the acquisition.
2 Service rendered as of 1/1/20X9 based on ABC's attribution election.
Amount attributed to post-combination vesting
$1,1003 - $5004 = $600
3 Entity ABC's cash settlement
4 Amount attributable to pre-combination vesting
The cash settlement of an award that is not vested at the acquisition date is similar to
the acquirer cash settling the acquiree's employee share options, because the settlement
eliminates any remaining requisite service periods. Because there is no post-
combination vesting required, ABC recognizes $600 of compensation cost immediately
in its post-combination financial statements. The measurement of pre-combination
vesting is based on ABC's policy of recognizing compensation cost ratably, rather than
DEF's accelerated attribution methodology (which is discussed in ASC paragraphs
718-20-55-29 and 55-30) and illustrated in Example 11.18).
CHANGE-IN-CONTROL PROVISIONS
11.036 Share option or other share-based compensation award plans often include a
provision that provides for the acceleration of awards in the event of a change in control
of the issuer (a change-in-control provision). Consistent with the guidance in ASC
paragraphs 805-20-55-50 and 55-51, entities should not anticipate the consummation of a
business combination. Instead, the remaining unrecognized compensation cost should be
recognized in the acquiree's financial statements when the business combination is
consummated.
11.037 In other instances, existing awards are sometimes modified to add a change-in-
control provision in contemplation of a change in control of an acquiree. The effect of the
change-in-control provision on the attribution of an acquirer's replacement award
between pre-combination and post-combination vesting depends on how the change-in-
control provision arose (i.e., the provision was included in the original acquiree award;
the provision was added through a modification of the acquiree award initiated by the
acquiree in contemplation of a change in control; or the provision was added through a
modification of the acquiree award at the request of the acquirer. See discussion
beginning at Paragraph 11.045).
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11. Determining What Is Part of the Business Combination Transaction
Recognition by an Acquiree of the Effect of Acceleration of Vesting of Awards
When a Change in Control Provision Is Triggered (Single Trigger)
11.038 If a change-in-control provision was included in the original terms of an acquiree
at the acquisition
award and that provision requires unvested awards to immediately vest
date, the shortened vesting period resulting from the triggering of the change-in-control
provision would be used for purposes of attributing the replacement award to pre-
combination and post-combination vesting. No post-combination vesting is required and,
if the fair value of both awards is the same, the total fair value-based measure of the
replacement award would be attributed to the consideration transferred in the business
combination, and no amount would be attributed to post-combination compensation cost.
This is illustrated in Example 11.20.
11.039 If separate financial statements of an acquiree are issued when push-down
accounting is not being elected, the remaining unrecognized compensation cost measured
from the acquiree's perspective (i.e., based on grant-date fair value when the award is
equity-classified) will be recognized in the acquiree's financial statements in the period
that includes the date that the acceleration of vesting is triggered (i.e., the acquisition
date).
11.040 If an acquiree issues separate financial statements and elects push-down
accounting, the acquiree recognizes the remaining unrecognized compensation cost in
either the predecessor period or on-the-line. See discussion in Paragraph 27.032.
Acceleration of Awards With a Change in Control and a Secondary Event (Double
Trigger)
11.041 In some situations the acceleration of vesting is contingent on an event in addition
to the change in control event (commonly referred to as a double trigger). In these
situations, if the additional triggering event is substantive and within the control of, or for
the benefit of, the acquirer or the combined entity, any expense related to the acceleration
of vesting would be recognized by the acquirer as post-combination compensation cost.
11.041a These types of triggers that are at the discretion of the acquirer could be in the
form of either taking an action or an inaction. For example, if the acquiree award contains
a double trigger such that the acceleration is triggered by both the change in control and
severance of an individual by the combined company (similar to Example 11.12 related
to double trigger cash severance payments), any expense related to the acceleration of
vesting would be recognized by the acquirer as post-combination expense. Another
example would be if the acceleration is contingent on approval by the acquirer. There
also may be instances when an acquiree award contains a change in control provision that
vesting accelerates if the acquirer does not issue new and/or replacement awards. Such
inaction by the acquirer that triggers the accelerated vesting would also be within the
control of the acquirer, and therefore, the compensation expense related to the accelerated
vesting would be recognized in the post-combination period.
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11. Determining What Is Part of the Business Combination Transaction
Modification of Acquiree Share-Based Compensation Awards Initiated by the
Acquiree in Contemplation of a Change in Control
11.042 If the original provisions of an acquiree's awards do not contain a change-in-
control provision and the acquiree modifies the terms of the awards to provide for
acceleration of vesting in the event of a change in control, the accounting will depend on
the facts and circumstances. Judgment should be used to determine whether the
modification was initiated by the acquiree in contemplation of the business combination
or initiated by the acquirer. Factors to consider include whether the entity is actively
pursuing potential targets and suitors, actively exploring strategic alternatives, or is in the
initial process of strategic planning that may evolve into more specific strategic
initiatives. If the acquiree effects the modification at its own initiative in contemplation of
a possible change in control but prior to specific discussions with the acquirer, that may
indicate that the modified terms will be incorporated into the acquirer's accounting for the
business combination. In those circumstances, the total vesting period and the original
vesting period would be the same for purposes of attributing the award to pre-
combination and post-combination vesting because of the modification of the award.
Accordingly, no post-combination vesting is required and if the fair value of both awards
is the same, the total fair-value-based measure of the replacement awards would be
attributed to the consideration transferred in the business combination and no amount
would be attributed to post-combination compensation cost. However, there may be
accounting required in the acquired entity’s financial statements. This is illustrated in
Example 11.21.
11.043 From the perspective of the acquiree, the modification of the award to include the
change-in-control provision may be a Type III modification (i.e., an improbable-to-
probable modification) and, as such, the acquiree would recognize cumulative
compensation cost associated with the modification in accordance with ASC paragraphs
718-20-55-109A, 55-109B, 55-116, 55-117, and 55-121, as applicable depending on
whether the award is to employees or nonemployees. However, if the modification was
determined to be a Type I modification (i.e., a probable-to-probable modification), the
acquiree would recognize cumulative compensation cost in accordance with ASC
paragraphs 718-20-55-110 through 55-112. See Example 11.21.
11.044 In contrast, if the acquiree initiates the modification once discussions with the
acquirer have moved beyond a preliminary stage, that action may indicate that the
modified terms should not be incorporated into the acquirer's accounting for the business
combination. In those circumstances, the accounting would be the same as when the
acquirer requests a modification of the terms of share-based payment awards as discussed
below and illustrated in Example 11.22.
Modifications of Acquiree Share-Based Compensation Awards at the Request of the
Acquirer in Contemplation of a Change in Control2
11.045 If a change-in-control provision is added to an acquiree's share-based payment
award at the request of an acquirer, the accounting would be the same as if the acquirer
issued a fully vested replacement award in exchange for the original unvested award. See
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11. Determining What Is Part of the Business Combination Transaction
discussion in this Section of Other Payments to an Acquiree (or Its Former Owners) That
Are not Part of the Consideration Transferred. For example, an acquirer may request an
acquiree to offer an acceleration of an existing award to a member of the acquiree's senior
management in exchange for termination of an employment contract because the acquirer
intends to integrate the roles and responsibilities of the senior management member into
those of the acquirer's existing senior management group. This is illustrated in Example
11.22.
11.046 The impact of the modification of the vesting provisions of share-based
compensation awards under each of the situations described above is illustrated in the
following examples.
Example 11.19a: Settlement of Share Awards on Consummation of a
Business Combination
On July 1, 20X7, XYZ Corp pays cash to acquire all of the outstanding equity securities
of ABC Corp., including outstanding share options. The share option awards contain a
change of control provision such that they immediately vest on a change in control of
ABC.
The grant-date fair value of the share options was $8 million. The fair value of the share
options on July 1, 20X7 is $10 million. All share awards vested at the date of the business
combination and the cash paid to redeem the share options was $10 million. ABC had
previously recognized $3 million of compensation cost related to the share options.
Acquirer’s Accounting
From XYZ’s perspective, it paid $10 million to settle fully vested awards. Accordingly,
the entire $10 million is included in the consideration paid by XYZ because there is no
future service required for either the original awards (which vested on change of control
included in the original terms) or the replacement award (cash settlement) and XYZ paid
an amount equal to the acquisition-date fair value of the awards.
Acquired Entity’s Accounting
Scenario 1. ABC elects not to apply pushdown accounting in its stand-alone financial
statements. In which quarter and how should ABC record the compensation costs?
Consistent with the guidance in ASC paragraphs 805-20-55-50 and 55-51, the remaining
compensation cost (based on the grant-date fair value) is recognized in the quarter that
includes July 1, 20X7.
Financial statements for the period ended June 30, 20X7 will disclose the cost to be
recognized in the subsequent period. On July 1, 20X7, ABC will record the settlement of
the share options as follows:
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11. Determining What Is Part of the Business Combination Transaction
Compensation cost
Paid-in capital-share options
APIC
Debit
Credit
5,000,0001
3,000,0002
2,000,000
Contributed capital from XYZ
10,000,0003
1 Grant-date fair value ($8,000,000) less compensation cost previously recognized ($3,000,000)
2 Eliminate paid-in capital from compensation cost previously recognized
3 Cash payment by XYZ to settle the share options
Scenario 2. ABC elects to apply pushdown accounting in its stand-alone financial
statements. How should the $5 million of unrecognized compensation cost be reflected in
the predecessor (period prior to the acquisition) and successor (period following the
acquisition) financial statements of ABC?
Because the recognition of compensation cost occurs on consummation of the business
combination, we believe that ABC can choose either to present the amount as
compensation cost in the predecessor financial statements (i.e., it is recognized
immediately before the consummation of the business combination as in Scenario 1) or to
reflect the amount in equity of the successor financial statements as part of acquisition
accounting adjustments, in which case no compensation cost would be presented in either
the predecessor or successor financial statements (i.e., the compensation cost is
recognized concurrent with the consummation of the business combination and,
therefore, falls on the black line that separates the predecessor / successor periods). (See
discussion in paragraph 27.032.) ABC should apply the same accounting for all liabilities
triggered by the consummation of the business combination. In either case, ABC should
disclose the accounting for these items.
Example 11.20: Original Share-Based Payment Award Provides for
Accelerated Vesting on Change in Control
On January 1, 20X7, DEF Corp. grants its employees 100,000 share options, with an
exercise price of $30 per share (equal to the grant date fair value of DEF's common
stock). The fair-value-based measure of the awards at the grant date is $1,000,000 ($10
per share option). The terms of the awards provide for cliff vesting at the end of four
years, and also provide for accelerated (immediate) vesting in the event of a change in
control of DEF. DEF’s accounting policy is to estimate forfeitures expected to occur.
Assume forfeitures are estimated at zero.
ABC Corp. acquires DEF on January 1, 20X9. Because of the change-in-control
provision, DEF's share awards immediately vest at the acquisition date. At that date, the
fair-value-based measure of the fully vested DEF awards is $2,000,000 ($20 per share),
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11. Determining What Is Part of the Business Combination Transaction
and ABC issues a fully vested replacement award to DEF employees with an equivalent
fair value of $2,000,000.
Before the acquisition date, 2 years of the original 4-year vesting period for the DEF
awards were complete. However, because the terms of the original award provide for
accelerated vesting of the DEF share option awards in the event of a change in control,
the change in control results in a change in the requisite service period (original service
period) from 4 years to 2 years and, as a result, the original service period and the pre-
combination vesting period are the same (2 years) for purposes of attributing the
replacement award to pre-combination and post-combination vesting.1
Because no post-combination vesting by the DEF employees is required, and since the
fair-value-based measure of the replacement awards issued by ABC (the acquirer) is
equal to the fair-value-based measure of the DEF awards, the entire fair-value-based
measure of the ABC replacement awards ($2,000,000) is attributed to pre-combination
vesting and included in the consideration transferred in the business combination. This
result is consistent with that shown in the illustration in Example 11.13, Acquirer
Replacement Awards That Require No Post-combination Vesting Exchanged for Acquiree
Awards for which Employees Have Rendered the Required Services as of the Acquisition
Date.
1 Accounting by DEF (acquiree): As a result of the acceleration of vesting, the acquiree awards are fully
vested at the acquisition date. Because the terms of the original awards provided for the acceleration of
vesting in the event of a change in control, DEF (the acquiree) recognizes cumulative compensation cost in
its separate financial statements equal to the fair value of the DEF awards as of the original grant date
($1,000,000). Because DEF would have recognized $500,000 in cumulative compensation cost prior to the
acquisition date (2 years/4 years × $1,000,000), DEF would recognize an additional $500,000 of
compensation cost in its separate financial statements at the acquisition date.
Example 11.21: Acquiree Initiates Modification of Share-Based
Compensation Awards in Contemplation of a Change in Control
Assume the same facts as in Example 11.20, except:
• The terms of the original DEF Corp. awards provide that in the event of a
change in control, the acquirer is obligated to replace the DEF awards with
identical replacement awards; however, there was no provision for
acceleration of vesting in the event of a change in control;
• DEF’s accounting policy is to estimate forfeitures and it previously had
estimated a forfeiture rate of 5%;
• DEF, in contemplation of a change in control, elects to modify the DEF
awards immediately preceding the acquisition to provide for accelerated
vesting of the awards in the event of a change in control (the fair-value-based
measure of the DEF awards before the modification is $2,300,000 and after
the modification is $2,000,000, because the awards have a shorter expected
term after the modification).
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11. Determining What Is Part of the Business Combination Transaction
Acquirer's Accounting
The attribution by ABC Corp. (the acquirer) of the replacement awards issued to the DEF
employees between pre-combination and post-combination vesting is the same as that
indicated in the preceding example. Because no post-combination vesting is required, and
since the fair-value-based measure of the replacement awards issued by ABC (the
acquirer) is equal to the fair-value-based measure of the DEF awards, the entire fair-
value-based measure of the ABC replacement awards ($2,000,000) is attributed to pre-
combination vesting and included in the consideration transferred in the business
combination.
Acquiree's Accounting
When an entity modifies an award at a point in time that could be considered to be in
contemplation of a business combination, there could be required accounting for the
modified award in the acquired entity's financial statements starting at the modification
date. Changes to the terms of awards in conjunction with a business combination are
modifications, and modification accounting is applied when there are changes to the fair
value, vesting conditions or classification of awards.
At the date of modification, DEF assessed the likelihood that the original awards would
have vested under their original terms and under the modified terms. In making this
determination, DEF assumes that the replacement awards ABC issued will continue to
vest under the original terms of the awards. Based on the estimated forfeiture rate of 5%,
DEF determined that 95% of the original awards would have continued to vest following
the change in control; however, because of the modification to accelerate vesting, the 5%
forfeiture rate is expected to be reduced to 0%. Therefore, for this example, DEF
determines that this modification, which changes the estimated forfeiture rate from 5% to
0%, is a Type III modification (i.e., improbable-to-probable) for those awards no longer
expected to be forfeited as a consequence of the modification (i.e., for 5% of the awards).
The awards expected to vest before and after the modification (95% of the awards) are a
Type I modification (i.e., probable-to-probable). This distinction between the portion of
the awards treated as a Type III modification (5%) versus the portion treated as a Type I
modification (95%) is based on the forfeiture assumption in place before the acquisition
date. Accordingly, DEF (the acquiree) would recognize cumulative compensation cost in
its separate financial statements equal to the grant date fair value of the awards expected
to vest before and after the modification plus the modification date fair value of the
awards expected to vest as of the modification date, which were not expected to vest
before the modification. Thus, cumulative compensation that would be reported in DEF's
financial statements would be $1,050,000 [($1,000,000 × 95%) + ($2,000,000 × 5%)]. Of
this amount, DEF would have recognized $475,000 ($1,000,000 × 95% × 2 years / 4 year
service period) prior to the modification. As a consequence, DEF would recognize
cumulative compensation cost of $575,000 subsequent to the modification.
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11. Determining What Is Part of the Business Combination Transaction
Example 11.22: Modifications of Acquiree Share-Based Compensation
Award at the Request of the Acquirer in Contemplation of a Change in
Control
On January 1, 20X8, DEF Corp. granted 10,000 share options with an exercise price of
$30 per share (equal to the grant date fair value of DEF's common stock). The fair-
value-based measure of the awards at the grant date was $1,000,000 ($10 per share
option). The terms of the award provide for cliff vesting at the end of four years. Also,
in the event of a change in control of DEF prior to the vesting date, an acquirer would
be obligated to issue identical replacement awards (i.e., all terms of the replacement
award are required to be the same as those of the DEF award). The awards do not
provide for acceleration of vesting upon involuntary termination (following a change in
control or otherwise).
ABC Corp. enters into an agreement to acquire DEF. Immediately following the
acquisition, ABC intends to integrate the roles and responsibilities of DEF’s
management group into those of ABC’s existing senior management group, which will
result in all of DEF’s employees with share-based payment awards being terminated.
ABC requests that DEF offer an acceleration of the vesting of the awards on closing of
the acquisition, in anticipation of the change in control.
ABC acquires DEF on January 1, 20X9. At that date, the fair-value-based measure of
the DEF awards is $2,000,000 ($20 per share option). As a result, at the acquisition
date (January 1, 20X9) the awards become fully vested, ABC issues fully vested
replacement awards in exchange for the DEF awards, and DEF's employees are
terminated.
In this example, because the modification of the awards and the decision to terminate
DEF employees are effected at the request of ABC (the acquirer), the attribution of the
fair-value-based measure of the replacement award issued by ABC between pre-
combination and post-combination vesting is the same as if:
• The DEF award had remained outstanding under its original terms at the
acquisition date;
• The DEF award had been exchanged for an identical replacement award
issued by ABC; and
• ABC had granted recipients of the replacement award immediate vesting in
exchange for termination of employment.
In other words, the termination of employment of DEF employees is not a part of the
business combination, but is a separate transaction required to be accounted for apart
from the business combination. See the discussion of Preexisting Relationships in this
Section.
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11. Determining What Is Part of the Business Combination Transaction
The attribution of the fair-value-based measure of the replacement award issued by
ABC to DEF employees follows the guidance illustrated in Example 11.17, Acquirer
Replacement Awards for which No Post-combination Vesting Is Required Exchanged
for Acquiree Awards for which Employees Have Not Rendered All of the Requisite
Service as of the Acquisition Date. The fair-value-based measure at the acquisition date
of both the DEF award and the replacement award is the same ($2,000,000). The
portion of the fair-value-based measure of the replacement award attributable to pre-
combination vesting equals the fair-value-based measure of the DEF award (the
acquiree award), or $2,000,000, multiplied by the ratio of the pre-combination vesting
period (1 year) to the greater of the total service period (1 year) or the original service
period of the DEF award (4 years).
Thus, $500,000 ($2,000,000 × 1/4) is attributable to pre-combination vesting and is
included in the consideration transferred in the business combination, and the excess of
the fair-value-based measure of the replacement award ($2,000,000) over the $500,000
attributed to the consideration transferred, or $1,500,000, is attributed to post-
combination vesting. Because no service by DEF's management group is required
following the acquisition, the $1,500,000 attributed to post-combination vesting is
immediately recognized as compensation cost in the post-combination financial
statements.
AWARDS WITH PERFORMANCE CONDITIONS
11.047 Under ASC Topic 718, awards with performance conditions require that
compensation cost be recognized when the achievement of the performance condition is
considered probable of achievement. If an award has multiple performance conditions
(and thus, for example, the number of options or shares to be awarded varies depending
on the performance condition(s) satisfied), compensation cost is accrued if it is probable
that a performance condition will be satisfied, based on the most likely outcome. When
an acquirer issues replacement awards, and both the original and replacement awards
include performance conditions, the determination of the pre-combination and total
vesting periods will be affected by the probability of achieving the performance
conditions. Specifically, the original vesting period of the acquiree's award should be the
vesting period used by the acquiree to accrue compensation cost as of the acquisition date
in accordance with ASC Topic 718. Similarly, the total vesting period should be based on
the original vesting period for the acquiree's award (determined as above), plus the
vesting period of the replacement award, determined in accordance with ASC Topic 718.
11.048 If, at the acquisition date, it is not probable that all performance conditions (if
any) included in either the acquiree's awards or the acquirer's replacement awards will be
met, then no amount is recognized as either pre- or post-combination vesting. If, in a
period subsequent to the acquisition date, it becomes probable that the performance
condition for the replacement award will be achieved, the acquirer recognizes the related
cumulative compensation cost in the post-combination financial statements in which such
period falls. In other words, the acquirer does not make adjustments to the consideration
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11. Determining What Is Part of the Business Combination Transaction
transferred in the business combination or the compensation cost recognized in the
previously issued post-combination financial statements.
11.049 Depending on the entity's operations subsequent to the business combination, it
may be challenging for an acquirer to structure a replacement award that has equivalent
performance conditions. For example, for employee awards, an entity may integrate the
operations of the target into the existing operations of one of its subsidiaries. That
subsidiary's operations may be such that the performance conditions of the target's
original award are not a relevant measure on which to set performance conditions for the
replacement award. In these circumstances, an acquirer may be required to issue
replacement awards that have only service conditions. Some share-based plans with
performance conditions have as part of their original terms that if the entity is acquired
and the acquirer is unable to issue replacement awards replicating the performance
conditions, the vesting of the replacement awards will automatically accelerate. The
accounting described beginning at Paragraph 11.029 is relevant in determining how the
award is allocated between pre-combination and post-combination vesting.
AWARDS WITH MARKET CONDITIONS
11.049a Under ASC Topic 718, market conditions affect the valuation of share-based
payment awards, and compensation cost is recognized if the service condition is met
regardless of whether the market condition is met. Similarly, in a business combination,
market conditions affect the measurement of both the acquiree's replaced award and the
acquirer's replacement award, based on circumstances at the acquisition date. Otherwise,
exchanges of awards with market conditions follow the same accounting treatment as
awards with service conditions. Unlike awards with performance conditions, for which
compensation is reversed if the condition is not achieved, compensation cost is not
reversed if a market condition is not achieved, provided the requisite service has been
rendered. For awards with market conditions, the allocation of pre-combination and post-
combination services is consistent with the analysis for awards with service conditions,
except that the market condition also is considered when determining the post-
combination service period.
POST-ACQUISITION CHANGES IN ESTIMATES
11.050 If an entity’s policy is to estimate forfeitures expected to occur, changes in the
number of replacement awards for which requisite service is expected to be rendered is
reflected as an adjustment to compensation cost in the period in which the changes in
estimated forfeitures occur. The acquirer therefore does not adjust consideration
transferred in periods subsequent to the acquisition date if actual forfeitures differ from
the forfeitures estimated at the acquisition date. An acquirer that elects to recognize
forfeitures as they occur also attributes the post-acquisition forfeiture experience to post-
acquisition compensation cost and will only reflect forfeitures as they occur. Stated
differently, any difference between the estimated and actual forfeitures of replacement
awards is reflected in compensation cost regardless of the acquirer’s policy for
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11. Determining What Is Part of the Business Combination Transaction
forfeitures; however, the pattern of recognition will differ under the two policies as
illustrated in Example 11.17c.
11.051 Likewise, an acquirer would not adjust the amount of consideration transferred for
other changes resulting from changes in estimates related to performance conditions or
other events or modifications occurring after the acquisition date, except for measurement
period adjustments. Judgment will sometimes be necessary to distinguish measurement
period adjustments from changes attributed to subsequent events. In general, the more
time that elapses following the acquisition date, the more likely it is that the adjustments
do not relate to facts and circumstances that existed at the acquisition date and should
therefore be reflected in post-combination earnings. See the discussion of Adjustments to
Provisional Amounts during the Measurement Period in Section 10.
11.052 The acquirer applies the same guidance as described above for determining
consideration transferred, regardless of the classification of the award. If the award is
liability classified, any subsequent changes in value (other than measurement period
adjustments), including the related tax effects, are recognized in the acquirer's post-
combination financial statements and not as an adjustment to the consideration
transferred.
11.052a Consistent with the accounting for awards issued to continuing employees, if
employee awards that were vested at the acquisition date subsequently expire
unexercised, no adjustment is made to either the consideration transferred or
compensation cost. In addition, for nonemployee awards, the same applies in that no
adjustment is made to either the consideration transferred or compensation cost when
there are expired unexercised awards.
LAST-MAN-STANDING PLANS
11.053 Occasionally, as part of a business combination, the acquirer will establish a
share-based payment award plan that provides for a specified number of awards with the
following conditions:
• Awards issued to employees under the terms of the business combination are
forfeited if employment is terminated within a certain time period; and
• Awards that are forfeited through termination of employment are reallocated
to the remaining employees.
11.054 These plans are sometimes referred to as last-man-standing plans. The forfeiture
and reallocation to other employees holding share-based payment awards issued as part
of a business combination constitutes the forfeiture of one award by a participant and a
grant of a new award to other participants. The acquiring entity should account for the
reallocated shares as a new grant (i.e., using a fair-value-based measure on the date of the
reallocation), and recognize the resulting compensation cost over the requisite service
period from the reallocation date. This accounting applies even though the awards issued
can never revert to the acquirer.
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11. Determining What Is Part of the Business Combination Transaction
Example 11.23: Last-Man-Standing Plans
ABC Corp. acquires DEF Corp. on January 1, 20X9. As required by the acquisition
agreement, ABC issues a replacement award of 500 share options with a fair value of
$7,500 ($15 /option) to replace share options for DEF's Last-Man-Standing Plan with a
fair value of $7,500.
Other relevant information about DEF's Last-Man-Standing Plan is as follows:
• On January 1, 20X7, DEF issued 500 share options with a fair value of $5,000
to 5 of its executives (100 options each).
• The original share options provided for cliff vesting at the end of the 3-year
period ending January 1, 20Y0.
•
If any of the executives terminate employment prior to January 1, 20Y0, the
forfeited awards are reallocated in equal amounts to the executives that remain
employed. On December 31, 20X8, one of the executives terminated
employment and 100 share options were reallocated to the four remaining
executives.
Amount of Replacement Awards Attributed to Pre-combination Vesting
The portion of the replacement awards attributed to pre-combination vesting is $4,000.
The determination of this amount requires two computations, because the originally
issued DEF awards that remain outstanding at the acquisition date and the options
reissued at December 31, 20X8 are accounted for as two separate awards. The portion of
the replacement award for the originally issued DEF awards and the reissued awards
attributed to pre-combination vesting is $4,000 and $0, as shown below.
Originally Issued and Outstanding Options
400 share options × $15 × 2/3 = $4,000
Computed as the acquisition-date fair-value-based measure of DEF's originally issued
and outstanding options at the acquisition date (400 × $15 = $6,000) multiplied by the
ratio of the pre-combination vesting period (2 years) to the greater of the total service
period or the original service period (both of which are 3 years).
Reissued Options
100 share options × $15 × 0 = $0
Computed as the acquisition-date fair-value-based measure of DEF's reissued options at
the acquisition date (100 × $15 = $1,500) multiplied by the ratio of the pre-combination
vesting period (none) over the greater of the total service period or the original service
period (both of which are 1 year). Because there was no pre-combination vesting period
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11. Determining What Is Part of the Business Combination Transaction
(i.e., the reissued awards were issued on December 31, 20X8), none of the fair-value-
based measure of the replacement awards is attributed to pre-combination vesting.
Amount of Replacement Awards Attributed to Post-combination Vesting
The portion of the replacement awards attributed to post-combination vesting is $3,500,
which is equal to the sum of the fair-value-based measure of each of the replacement
awards less the amount attributed to pre-combination vesting, as shown below.
Fair-value-based measure of replacement awards for
originally issued and outstanding DEF awards ($6,000) less
amount attributed to pre-combination vesting ($4,000)
Fair-value-based measure of replacement awards for
reissued awards ($1,500) less amount attributed to pre-
combination vesting ($0)
$
2,000
1,500
3,500
$
These computations assume that no additional forfeitures are expected. If, after the
acquisition, replacement options held by the former DEF executives are forfeited and new
options are reallocated and reissued by ABC to the remaining former DEF executives, the
reissued options would be accounted for as a forfeiture of the awards issued at the
acquisition date by ABC, and as a grant of new awards in its post-combination financial
statements.
ACQUISITION OF NONCONTROLLING INTEREST
11.054a Ordinarily, settling an outstanding share option in a subsidiary, either in cash or
by issuing stock or share-based awards in the parent, is treated as a modification of an
award. However, the exchange of share-based awards or awards for consideration from
the parent is treated as the acquisition of a noncontrolling interest if:
• Those share-based awards were outstanding at the date the parent first gained
control of the subsidiary, and
• Those share-based awards have not been modified subsequent to the parent
gaining control.
11.054b If there is a future requisite vesting period associated with the new awards issued
by the parent, the proportionate amount of the consideration issued in the acquisition of
the noncontrolling interest related to the future vesting should be recognized as post-
acquisition compensation cost.
11.054c Example 11.23a summarizes whether an exchange of awards as part of a
transaction that is the acquisition of noncontrolling interest for five different
circumstances should be accounted for as either (1) acquisition of noncontrolling interest
or (2) a modification of awards.
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11. Determining What Is Part of the Business Combination Transaction
Example 11.23a: Treatment of the Exchange of Awards in the Acquisition of
Noncontrolling Interest
Acquisition of
Noncontrolling
Interest
Modification
Awards fully vested at the date of the acquisition
of the subsidiary
Awards partially vested at the date of the
acquisition of the subsidiary and vest before the
exchange
Awards partially vested on the date of the
acquisition of the subsidiary and not fully vested at
the date of the exchange1
Awards fully vested but issued after the date of the
acquisition of the subsidiary2
Awards partially vested but issued after the date of
the acquisition of the subsidiary3
X
X
X
X
X
1 In this scenario, the exchange of awards would be treated as the acquisition of a noncontrolling interest.
However, the proportionate amount of the consideration relating to the future requisite service period
should be recognized as post-combination compensation cost and unrecognized compensation would be
recognized immediately.
2 In this scenario, the exchange of awards would be treated as a modification. Changes to the terms of
awards in conjunction with a business combination are modifications, with modification accounting applied
when there are changes to the fair value, vesting conditions or classification of awards. Accordingly, a
calculation to determine whether there is incremental compensation cost of the modification is required.
The amount paid for the fully vested awards that is equal to or less than the fair value of the award before
the exchange would be treated as the acquisition of a noncontrolling interest.
3 In this scenario, the exchange of awards would be treated as a modification. Changes to the terms of
awards in conjunction with a business combination are modifications, with modification accounting applied
when there are changes to the fair value, vesting conditions or classification of awards. Accordingly, a
calculation to determine whether there is incremental compensation cost of the modification is required and
incremental compensation cost relating to the modification of an unvested award is recognized for the
remaining vesting term.
Example 11.23b: Accounting for the Exchange of Partially Vested Awards
at the Acquisition Date of the Subsidiary
DEF Corp. issued 1,000 share options to employees on January 1, 20X5. The share
options vest over a three-year period with a grant-date fair value of $5 and an exercise
price of $10. DEF’s accounting policy is to account for forfeitures as they occur.
However, no share options were forfeited. On January 1, 20X7, ABC Corp. acquired
60% of DEF. The share options had an acquisition date fair value of $6.
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11. Determining What Is Part of the Business Combination Transaction
On January 1, 20X8, ABC exchanged fully vested replacement share options for the DEF
fully vested share options outstanding. Both the replacement share options and the
outstanding share options had a fair value of $8 on the date of replacement.
ABC would account for the exchange as an acquisition of noncontrolling interest as the
original share options were outstanding as of the acquisition date. ABC would record the
following entries from January 1, 20X7 through January 1, 20X8:
January 1, 20X7 (acquisition date)
APIC
Noncontrolling interest
December 31, 20X7
Expense
Noncontrolling interest
January 1, 20X8 (replacement date)
Noncontrolling interest
APIC
Debit
4,000
2,000
6,000
Credit
4,0001
2,0002
6,000
1 Pre-combination portion of the award based on acquisition date fair value (1,000 awards × $6 × 2/3)
2 Post-combination compensation cost based on the proportion of service rendered in the post-combination
period (1,000 awards × $6 × 1/3)
Example 11.23c: Accounting for the Exchange of Fully Vested Awards
Issued after the Acquisition Date of the Subsidiary
ABC Corp. acquired 60% of DEF Corp. on January 1, 20X4. Subsequent to the
acquisition date, on January 1, 2005, DEF issued 1,000 share options to employees that
vest over a three-year period. The share options had a grant-date fair value of $5 and an
exercise price of $10. DEF’s accounting policy election is to account for forfeitures as
they occur. However, no share options were forfeited. On January 1, 20X9, ABC
exchanged fully vested replacement share options for each DEF fully vested share option
outstanding. The replacement share options had a fair value of $8 on the date of
exchange. The fair value of the share options of DEF immediately before the
modification is $6. Assume no share options in DEF have been exercised.
ABC would account for the exchange as a modification as the share options were issued
subsequent to the acquisition date. ABC would immediately recognize additional
compensation cost for the incremental fair value of $2,000 representing the post-
acquisition compensation cost, because the replacement share options do not have a
future requisite service period. In addition, ABC would record the amount paid for the
fair value of the fully vested share options prior to the exchange as an acquisition of
noncontrolling interest. Noncontrolling interest would be capped at the grant-date fair
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11. Determining What Is Part of the Business Combination Transaction
value of $5,000 (i.e., the amount of noncontrolling interest recognized related to the share
options ($5 × 1,000 share options)). ABC would record the following:
Compensation cost
Noncontrolling interest
APIC
Debit
2,000
5,000
Credit
7,000
ACQUIRER'S ACCOUNTING FOR UNREPLACED AWARDS
11.055 In some business combinations, the acquirer may not replace outstanding acquiree
employee or nonemployee share-based payment awards. This may occur in situations
where the acquirer acquires less than 100% of the shares of the acquiree and the terms of
the acquiree’s awards permit them to remain outstanding and continue to vest under their
original terms. In that situation, the acquirer determines the fair value of the acquiree’s
awards at the acquisition date. This amount constitutes the grant-date fair value of the
awards for the acquirer’s post-combination accounting. That is, the acquisition date fair
value of the acquiree share-based awards that remain outstanding is used as the basis for
determining the compensation cost in the acquirer’s post-combination financial
statements based on the proportion of service required (or goods expected to be delivered
for nonemployee awards) in the post-combination period. The pre-combination portion of
the award is reflected as noncontrolling interest in the acquirer’s consolidated financial
statements. For example, if the acquiree’s employee awards had a fair value of $50,000 at
the acquisition date and the employees had provided three years of service out of a
requisite service period of five years, the acquirer would reflect $30,000 as
noncontrolling interest in its acquisition accounting. It would then recognize
compensation cost of $20,000 over the remaining two-year service period.
ACQUIRER’S SUBSEQUENT GRANT OF AWARDS WHEN ACQUIRER DID NOT
EXCHANGE ACQUIREE’S AWARDS IN THE BUSINESS COMBINATION
TRANSACTION
11.055a In some business combinations, the acquirer may not replace outstanding
acquiree share-based awards. Subsequently, the acquirer may grant new share-based
awards to those former target company employees and nonemployees. Generally, these
awards should not be part of the consideration transferred in the acquisition of the
acquiree unless the acquirer was obligated to replace the awards under the terms of the
acquisition agreement, the terms of the acquiree’s award agreements or applicable law.
When the new grants are made shortly after the acquisition date, judgment may be
required to determine whether there was a legal obligation to replace the outstanding
share-based awards if not explicitly stated in the acquisition agreement or terms of the
acquiree’s award agreements. In that case, it may be necessary to consult with legal
counsel to evaluate the obligation under the applicable laws and regulations.
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11. Determining What Is Part of the Business Combination Transaction
Example 11.23a: Employee Share Options of Acquiree That Are Not
Assumed by the Acquirer
Background
ABC Corp (an acquirer in a business combination) was not legally obligated to, and did
not, assume, acquire, or exchange the outstanding share options of DEF Corp. (the
Acquiree). In accordance with the terms of DEF’s outstanding share options, the
employees had 90 days after a change in control to exercise vested share options.
Because these share options were out-of-the-money, the share options expired
unexercised. Subsequently, ABC granted share options to employees, including
employees that were formerly employed by DEF, in an amount and with terms that
were consistent with ABC’s past practice for annual grants. Employees in similar
positions received the same number of share options regardless of whether they were
previously employed by DEF.
Q. Should ABC record the fair value of the share options granted to DEF’s former
employees as additional consideration transferred in the acquisition of DEF?
A. No. ABC should not record the fair value of the share options as additional
consideration transferred. ABC was not obligated to assume DEF’s outstanding share
options. Additionally, ABC did not agree to compensate DEF employees for their
lapsed share options. ABC granted new share options in an amount that was consistent
with its past practices for annual grants and did not grant a disproportionate amount of
share options to DEF’s former employees. Accordingly, ABC should not record any
portion of the fair value of the new share options as additional consideration or
otherwise attribute the new awards to the acquisition of DEF.
11.055b Paragraph not used.
PAYROLL TAXES ON SHARE-BASED AWARDS
11.055c The liability for employer payroll taxes should be recognized on the date that
measurement and payment of the payroll tax is required (triggering event), which
generally is the exercise date of share options. A liability should not be recognized as part
of the consideration transferred if the triggering event has not occurred at the acquisition
date. Additionally, no adjustment to the consideration transferred should be made when
the triggering event occurs after the acquisition date. This view is consistent with ASC
paragraph 718-10-25-22, which addresses recognition of employer payroll taxes on
employer share-based compensation.
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11. Determining What Is Part of the Business Combination Transaction
ACCOUNTING FOR THE INCOME TAX EFFECTS OF
REPLACEMENT AWARDS CLASSIFIED AS EQUITY ISSUED IN A
BUSINESS COMBINATION
See KPMG Handbook Accounting for Income Taxes, Section 6, The Tax Effects of
Business Combinations.
11.056 - 11.060 Paragraphs not used.
ACQUISITION-RELATED COSTS
ACQUISITION-RELATED COSTS INCURRED BY THE ACQUIRER
ASC Paragraph 805-10-25-23
Acquisition-related costs are costs the acquirer incurs to effect a business
combination. Those costs include finder's fees; advisory, legal, accounting,
valuation, and other professional or consulting fees; general administrative costs,
including the costs of maintaining an internal acquisitions department; and costs
of registering and issuing debt and equity securities. The acquirer shall account
for acquisition-related costs as expenses in the periods in which the costs are
incurred and the services are received, with one exception. The costs to issue debt
or equity securities shall be recognized in accordance with other applicable
GAAP.
11.061 Acquisition-related costs incurred by an acquirer to effect a business combination
are not part of the consideration transferred, but rather are accounted for as expense in the
period incurred, unless such costs are incurred to issue debt or equity securities, in which
case they are recognized in accordance with other applicable GAAP. Success fees
incurred by the acquirer for external advisors (such as an investment banker) that are
contingent on the closing of an acquisition are not recorded as a liability or expense until
the completion of the acquisition, as the expense is not incurred until the closing of the
business combination. Therefore, the success fee expense is recorded in the financial
statement period that includes the acquisition date.
11.062 If acquisition-related costs incurred by an acquirer are paid by the acquired entity
or selling shareholders, those costs are accounted for as a separate transaction and are not
part of the accounting for the business combination. See Other Payments to an Acquiree
(or its Former Owners) That Are Not Part of the Consideration Transferred below.
11.062a There may be circumstances in which the combined entity pays transaction-
related costs incurred by an acquiree. In these scenarios, the factors outlined in ASC
paragraph 805-10-55-18 (see Paragraphs 11.000 to 11.005) should be considered to
determine whether the costs form part of the business combination. For example, if a
contingent finder’s fee arrangement was entered into by the acquiree for its own benefit
without the acquirer's involvement, the expense would not be recorded on the post-
acquisition financial statements of the combined entity. In that case, the assumed liability
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11. Determining What Is Part of the Business Combination Transaction
would be recorded as part of the accounting for the business combination. In contrast, if
the acquiree entered into the contingent fee arrangement for services provided to and for
the benefit of the acquirer, the costs would be an expense of the acquirer in the financial
statement period that includes the acquisition date rather than a liability assumed in a
business combination. See Paragraph 27.032 for a discussion of contingent expenses of
the acquiree when pushdown accounting is applied to the acquiree's financial statements.
Example 11.26: Acquisition-Related Costs
ABC Corp. acquires 100% of the stock of DEF Corp., a foreign company, for cash.
The foreign government requires a 1% stamp duty to be paid by ABC within 30 days
of the transfer of stock to legally document the transfer of ownership. The stamp duty
is the legal obligation of ABC.
The stamp duty paid by ABC is not part of the consideration transferred for the
acquisition of DEF and therefore is expensed in the period in which the cost is
incurred.
Q&A 11.1: Costs Related to Directors and Officers Liability Insurance
Background
Following an acquisition, several of an acquiree's former executives and officers were
terminated. The acquirer obtained directors and officers insurance to insure against
issues that might arise from the period that the former executives and officers served in
their capacity for the acquiree.
Q. How should an entity account for the cost of a directors and officers liability
insurance policy acquired to cover former officers of an acquiree?
A. The entity should expense the costs when incurred. It would not be appropriate to
amortize the costs over the statute of limitations period or other periods because the
periods over which the acquirer would receive a benefit from this cost is
indeterminable. Furthermore, the cost relates to issues that may arise from actions
taken before the acquisition. The cost of the insurance policy is not considered to be an
acquisition cost.
Costs Related to the Issuance of Equity Securities
11.063 An acquirer may incur costs related to the issuance of equity securities issued to
effect a business combination. Such costs may include direct, incremental costs of the
issuance, such as fees charged by underwriters, attorneys, accountants, and printers.
These costs effectively reduce the proceeds from the stock issuance and, therefore, should
reduce the amount recognized in equity. An entity should record internal costs, such as
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11. Determining What Is Part of the Business Combination Transaction
salaries, as current period expenses, because such costs would have occurred even
without the issuance of the equity securities.
Costs Related to the Issuance of Debt
11.064 An acquirer may incur costs in connection with the issuance of debt associated
with a business combination. For example, such costs may include fees paid to creditors,
attorneys, and rating agencies. Debt issue costs reduce the proceeds from the debt issued,
and are an element of the effective interest cost of the debt, and neither the source of the
debt financing nor the use of the proceeds change the nature of such costs. Direct costs
paid to third parties in connection with a debt issuance, whether in a transaction related to
a business combination or otherwise, should be capitalized and amortized over the term
of the debt as a component of interest cost. Entities should not capitalize internal costs
related to the issuance of debt.
11.065 An entity may incur fees in connection with the issuance of debt and also pay fees
to the same service provider/creditor in a related business combination. The fees
allocated to the debt issuance and the cost of the acquisition should be representative of
the actual services provided. For example, if an entity pays fees to an investment banker
in connection with a business combination and financing, those fees should be allocated
between the costs of the acquisition and debt issuance costs considering factors such as
the fees charged by investment bankers in connection with other similar recent
transactions (e.g., fees charged by an investment banker solely for advisory services for
an acquisition or fees charged by an investment banker solely for arranging financing).
Whether these or other factors are considered, the allocation should normally result in an
effective debt service cost (interest and amortization of debt issuance costs) that is
comparable to the effective cost of other recent debt issues of similar investment risk and
maturity. SAB Topic 2A
OTHER PAYMENTS TO AN ACQUIREE (OR ITS FORMER OWNERS) THAT ARE
NOT PART OF THE CONSIDERATION TRANSFERRED
Statement 141(R)
B370. The Boards also considered concerns about the potential for abuse. Some
constituents, including some respondents to the 2005 Exposure Draft, said that if
acquirers could no longer capitalize acquisition-related costs as part of the cost of
the business acquired, they might modify transactions to avoid recognizing those
costs as expenses. For example, some said that a buyer might ask a seller to make
payments to the buyer's vendors on its behalf. To facilitate the negotiations and
sale of the business, the seller might agree to make those payments if the total
amount to be paid to it upon closing of the business combination is sufficient to
reimburse the seller for payments it made on the buyer's behalf. If the disguised
reimbursements were treated as part of the consideration transferred for the
business, the acquirer might not recognize those expenses. Rather, the measure of
the fair value of the business and the amount of goodwill recognized for that
business might be overstated. To mitigate such concerns, [ASC Topic 805]
requires any payments to an acquiree (or its former owners) in connection with a
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11. Determining What Is Part of the Business Combination Transaction
business combination that are payments for goods or services that are not part of
the acquired business to be assigned to those goods or services and accounted for
as a separate transaction. [ASC Topic 805] specifically requires an acquirer to
determine whether any portion of the amounts transferred by the acquirer are
separate from the consideration exchanged for the acquiree and the assets
acquired and liabilities assumed in the business combination. [ASC paragraphs
805-10-25-20 through 25-23 and 55-18] provide guidance for making that
determination.
11.066 The guidance in the above paragraph, and the guidance in ASC paragraphs 805-
10-25-20 through 25-23 and 55-18 previously discussed, was included in ASC Topic 805
in part to mitigate concerns over whether an acquirer might arrange for an acquiree to
make payments for goods or services on behalf of the acquirer that are unrelated to the
acquisition. That guidance requires an acquirer to determine whether any portion of the
consideration transferred relates to such transactions and, if so, to exclude such
transactions from the acquisition accounting and, instead, assign a portion of the
consideration transferred to such transactions and account for them as separate
transactions in accordance with other relevant guidance. Since the costs are a separate
transaction, the acquirer should recognize an expense and liability for reimbursement to
the acquiree as these costs are incurred.
Example 11.27: Acquisition-Related Payments Made by an Acquiree
ABC Corp. acquires DEF Corp. for $10,000. The acquisition agreement states that the
price is comprised of $9,500 as consideration for DEF and $500 as reimbursement of
DEF's acquisition-related transaction costs. The cost of $500 is entirely DEF's cost and
no costs were incurred by DEF on behalf of ABC.
The following amounts are the value of DEF's assets and liabilities measured in
accordance with ASC Topic 805 on the acquisition date:
Current assets
Current liabilities (excluding accruals for
transaction costs)
Long-lived assets
Debt
$3,000
$2,000
$8,000
$5,000
ABC treats the entire $10,000 as consideration transferred for the purpose of
determining goodwill. This is based on the guidance in ASC paragraph 805-10-55-18.
As the reimbursement by ABC of DEF's costs is for the primary benefit of DEF, the
costs are more likely part of the exchange for the acquiree. Accordingly, ABC would
record the following:
Debit
Credit
Current assets
Long-lived assets
3,000
8,000
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11. Determining What Is Part of the Business Combination Transaction
Goodwill
6,000
Current liabilities
Debt
Cash
2,000
5,000
10,000
Conversely, if the transaction costs were included in the acquiree's accounts payable to
be paid by the combined company, it would be expected that the offer price would be
reduced to $9,500 and ABC would record the following:
Current assets
Long-lived assets
Goodwill
Current liabilities
Debt
Cash
3,000
8,000
6,000
2,500
5,000
9,500
This example only applies to costs incurred by and related to the acquiree.
OTHER TRANSACTIONS
CHANGES IN INTEREST RATE ON ACQUIRER'S DEBT RESULTING FROM A
CHANGE IN CONTROL
11.067 The acquirer in a business combination may have outstanding debt with
provisions that could result in an increase in the interest rate in the event of a merger or
acquisition. If the interest rate on debt of the acquirer is increased as a result of a business
combination, the additional interest costs are not part of the business combination
transaction and therefore are not included in the consideration transferred. The additional
interest costs are recognized by the acquirer as incurred or accreted.
COSTS CONTINGENT ON A BUSINESS COMBINATION
11.068 In connection with a business combination, an acquirer may choose to exit an
activity of the acquiree, involuntarily terminate employees of the acquired entity, or
relocate employees of the acquired entity. Costs resulting from such activities are costs of
the combined entity and are not part of the consideration transferred. The accounting for
such costs is discussed in ASC Subtopic 420-10, Exit or Disposal Cost Obligations -
Overall. Costs incurred to integrate the acquired entity into the operations of the
accounting entity would also not be part of the consideration transferred. See discussion
of Liabilities Associated with Restructuring or Exit Activities of the Acquiree in Section
7.
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11. Determining What Is Part of the Business Combination Transaction
HEDGING A FORECASTED TRANSACTION CONTINGENT ON
CONSUMMATION OF A BUSINESS COMBINATION
11.069 ASC paragraph 815-20-25-43 prohibits fair value hedge accounting of a firm
commitment to enter into a business combination or to acquire a subsidiary, minority
interest, or equity method investee. ASC paragraphs 815-20-25-15(g) and 25-15(h) are
explicit in their guidance in prohibiting cash flow hedge accounting for a forecasted
transaction involving a business combination or acquisition of a subsidiary,
noncontrolling interest, or equity method investee. The FASB's Derivatives
Implementation Group (DIG) has discussed whether it is appropriate to designate the
occurrence of a forecasted transaction that is contingent on consummating a business
combination as the hedged item in a cash flow hedge.
Example 11.28: Derivative Transaction That Will Lock In the Interest Rate
Today on the Forecasted Issuance of Debt Expected to Occur in Six
Months
The following example is derived directly from DIG Agenda Item 14-13:
Company A enters into a definitive agreement to acquire the outstanding common
stock of Company B for cash. The transaction is expected to close in six months. Given
the significance of the purchase price relative to its cash balance, Company A needs to
borrow money immediately before the closing of the transaction to fund the
acquisition. However, in the unlikely event that the transaction with Company B is not
consummated, Company A will not incur the debt as it has sufficient working capital to
meet its operational needs. Company A is concerned that interest rates will increase
during the next six months and, therefore, desires to enter into a derivative transaction
that will lock in the interest rate today on the forecasted issuance of the debt expected
to occur in six months.
11.070 While the FASB staff has not reached a definitive conclusion on the appropriate
accounting treatment for the above example, we believe that it is acceptable to hedge a
forecasted transaction that is contingent on the consummation of a business combination
if the forecasted transaction does not directly affect the accounting for the acquisition and
meets the criteria for being the hedged item as defined by ASC paragraph 815-20-25-15.
In the above example, the forecasted issuance of debt does not directly affect the
accounting for the acquisition.
11.071 If Company A determines that it is probable that the business combination will be
consummated, that the forecasted transaction is likely to occur, and that all the other
relevant hedging criteria in ASC paragraphs 815-20-25-3, 25-15, 25-75, 25-94, and 25-95
have been met, then cash flow hedge accounting would be appropriate for the forecasted
transaction. It is important to note that the facts and circumstances related to the
forecasted business combination need to be evaluated to determine whether the
transaction is probable.
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11. Determining What Is Part of the Business Combination Transaction
11.072 Certain constituents have argued that the consensus reached in EITF Issue No. 95-
14, "Recognition of Liabilities in Anticipation of a Business Combination" (which was
nullified by ASC Subtopic 420-10), does not support the assertion that a forecasted
business combination can be probable of occurring before the consummation of the
business combination. We believe that reference to EITF 95-14 is not appropriate, as the
Issue was narrow in scope and addressed only the recognition of liabilities in anticipation
of a business combination. EITF 95-14 did not specifically address whether a forecasted
business combination could ever be considered likely to occur.
11.073 Furthermore, to the extent an entity concludes that a business combination is
probable of occurring for purposes of hedging a forecasted transaction contingent on the
consummation of a business combination, an entity also would conclude that the business
combination is probable of occurring for purposes of SEC Rule 3-05 of Regulation S-X.
This rule provides, in part, that audited financial statements prepared under Regulation S-
X are required if the consummation of a significant business combination is considered
probable.
1 Based on Case C in ASU 2018-07.
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Section 12 - Subsequent Measurement
and Accounting
Detailed Contents
Reacquired Rights
Example 12.1: Reacquired Right Subsequently Sold to a Third Party
Assets and Liabilities Arising from Contingencies
Indemnification Assets
Example 12.2: Subsequent Accounting for Indemnification Asset When
Estimated Collectibility Changes
Example 12.3: Subsequent Accounting for an Indemnification Asset When the
Amount of the Related Indemnified Liability Decreases and the Fair Value of the
Assets Securing the Indemnification also Decreases
Derecognition of Indemnification Assets
Example 12.4: Subsequent Settlement of an Indemnified Tax Uncertainty at Less
Than the Liability and Related Indemnification Asset Recognized at the
Acquisition Date
Defensive Intangible Assets
Defensive Assets Used in IPR&D Activities
Other Defensive Intangible Assets
Example 12.5: Acquired Trade Name the Acquirer Intends to Hold for Defensive
Purposes
Contingent Consideration
Subsequent Measurement of Contingent Consideration
Subsequent Measurement of Equity-Classified Contingent Consideration
Subsequent Measurement of Liability-Classified Contingent Consideration
Example 12.5a: Attribution of Changes in a Contingent Consideration Liability to
a Noncontrolling Interest
Contingently Issuable Debt
Other Applicable GAAP
Example 12.5b: Subsequent Accounting for a Liability for an Unfavorable
Executory (Revenue) Contract
Consistency of Accounting Policies
Error Discovered after a Business Combination
Example 12.6: Subsequent Discovery of Errors in Acquiree’s Financial
Statements
Example 12.7: Litigation with Dissenting Shareholders
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ASC Paragraph 805-10-35-1
In general, an acquirer shall subsequently measure and account for assets
acquired, liabilities assumed or incurred, and equity instruments issued in a
business combination in accordance with other applicable generally accepted
accounting principles (GAAP) for those items, depending on their nature.
However, [ASC] Topic [805] provides guidance on subsequently measuring and
accounting for any of the following assets acquired, liabilities assumed or
incurred, and equity instruments issued in a business combination:
a. Reacquired rights (see [ASC] paragraph 805-20-35-2)
b. Assets and liabilities arising from contingencies recognized as of the
acquisition date (see [ASC] paragraph 805-20-35-3)
c. Indemnification assets (see [ASC] paragraph 805-20-35-4)
d. Contingent consideration (see [ASC] paragraph 805-30-35-1)
e. Contingent consideration arrangements of an acquiree assumed by the
acquirer (see [ASC] paragraph 805-30-35-1A).
12.000 Recognition and measurement of the assets acquired, liabilities assumed or
incurred, and equity instruments issued in a business combination is discussed in Section
7, Recognizing and Measuring the Identifiable Assets Acquired, the Liabilities Assumed,
and Any Noncontrolling Interest in the Acquiree. Subsequent to an acquisition, an
acquirer accounts for most of the assets acquired, liabilities assumed or incurred, and
equity instruments issued in an acquisition in accordance with other applicable GAAP.
However, for the items specified in ASC paragraph 805-10-35-1, guidance is provided in
ASC paragraphs 805-20-35-2 through 35-4C and 40-2 and 40-3. Additionally, as
discussed beginning at Paragraph 12.015, guidance on accounting for defensive
intangible assets is provided in ASC paragraphs 350-30-25-5, 35-5A and 35-5B, 55-1 and
55-1B, 55-28H, 55-28I, 55-28K, 55-28L.
REACQUIRED RIGHTS
ASC Paragraph 805-20-35-2
A reacquired right recognized as an intangible asset in accordance with [ASC]
paragraph 805-20-25-14 shall be amortized over the remaining contractual period
of the contract in which the right was granted. An acquirer that subsequently sells
a reacquired right to a third party shall include the carrying amount of the
intangible asset in determining the gain or loss on the sale.
12.001 Consistent with the exception to the fair value measurement principle with respect
to the initial measurement of a reacquired right, ASC Topic 805 requires the acquirer to
amortize a reacquired right over the remaining contractual period of the related contract
in which the right was granted, even if market participants would consider potential
contract renewals in determining fair value. Thus, ASC paragraphs 350-30-50-4 through
50-5, 55-1C, and 275-10-50-15A are not applicable to the determination of the useful life
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12. Subsequent Measurement and Accounting
of a reacquired right. Section 7 discusses the initial recognition and measurement of
reacquired rights at the acquisition date.
12.002 If an acquirer subsequently sells a reacquired right to a third party, the carrying
amount of the intangible asset is included in the determination of the gain or loss on the
sale.
Example 12.1: Reacquired Right Subsequently Sold to a Third Party
ABC Corp., a franchisor, acquires DEF Corp. on April 30, 20X8 in a business
combination. ABC had a preexisting relationship with DEF and recognizes an intangible
asset related to a reacquired franchise right previously granted to DEF. ABC applied the
measurement principle in ASC paragraph 805-20-30-20 and determined the value of the
reacquired franchise right to be $100,000, based on the remaining contractual period of
five years as of the acquisition date. ABC did not consider potential contract renewals in
determining fair value, even though a market participant would consider such renewals.
Consistent with the term used for measuring the reacquired franchise right, ABC will
amortize the reacquired right over the remaining contract period (five years). ABC did
not recognize any settlement gain or loss on the business combination because the royalty
rate that DEF was paying under the franchise agreement was consistent with the current
market rate at the acquisition date. Two years later on April 30, 20X0, ABC sells the
reacquired franchise right to XYZ Corp. for cash of $210,000, with an initial contract
period of 10 years. Assume that all material services related to the sale of the franchise
right to XYZ have been substantially performed by ABC, and that all of the requirements
for recognition of revenues from franchise sales have been met.
ABC should derecognize the intangible asset of $60,000 ($100,000 less two-year
amortization of $40,000) and reflect the net effect of $150,000 ($210,000 received from
XYZ—carrying amount of $60,000 for the intangible asset) in earnings, presented in its
income statement in a manner consistent with its reporting of other revenues from
franchise sales (see ASC Subtopic 952-605, Franchisors - Revenue Recognition).
ASSETS AND LIABILITIES ARISING FROM CONTINGENCIES
ASC Paragraph 805-20-35-3
An acquirer shall develop a systematic and rational basis for subsequently
measuring and accounting for assets and liabilities arising from contingencies
depending on their nature.
12.003 ASC Topic 805 requires that assets and liabilities arising from contingencies of an
acquiree be recognized and measured at fair value at the acquisition date if fair value can
be determined during the measurement period. If not, these items are recognized in
accordance with the recognition and measurement provisions of ASC Topic 450,
Contingencies. Any gains or losses attributable to pre-acquisition contingencies that are
not recognized at acquisition date or within the measurement period are recorded outside
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of purchase accounting. See Section 7 for a discussion of initial recognition and
measurement of assets and liabilities arising from contingencies.
12.004 ASC paragraphs 805-10-35-1, 805-20-25-15A, 25-18A, 25-19 through 25-20B,
30-9, 30-9A, 30-23, 35-3 and 35-4C, 50-1, and 805-30-35-1A do not provide guidance on
the subsequent accounting for contingencies recognized in a business combination.
Instead, the FASB directs entities to “develop a systematic and rational basis for
subsequently measuring and accounting for assets and liabilities arising from
contingencies depending on their nature.”
12.005 We expect that in most circumstances entities will continue their current practices
when contingencies are recognized and measured in the acquisition accounting using an
ASC Topic 450 approach—which likely is a continuation of the ASC Topic 450
approach until the contingency is resolved (see related discussion in Paragraphs 7.156 -
7.157). However, in the case of warranty obligations or other contingencies that are
initially recognized at fair value, ASC paragraphs 805-20-25-17 and 25-28 suggest that
ASC Subtopic 460-10, Guarantees - Overall, might be a potential source of guidance on
the subsequent accounting. In accordance with ASC Subtopic 460-10, entities might
amortize the initially measured amount to income over the contingency period (i.e., the
warranty period) or they might continue to measure the contingency at its acquisition-
date fair value until its resolution.
12.005a After adopting ASC Topic 606, the accounting for warranties is differentiated
between assurance-type and service-type warranties. In both cases, the assumed liability
is measured at fair value. The subsequent accounting for assurance-type warranties is
consistent with the methods described in Paragraph 12.005. However, service-type
warranties are accounted for as unfulfilled performance obligations under ASC Topic
606. See Section 4.5.20 in KPMG Handbook, Revenue recognition.
INDEMNIFICATION ASSETS
ASC Paragraph 805-20-35-4
At each subsequent reporting date, the acquirer shall measure an indemnification
asset that was recognized in accordance with [ASC] paragraphs 805-20-25-27
through 25-28 at the acquisition date on the same basis as the indemnified liability
or asset, subject to any contractual limitations on its amount except as noted in
paragraph 805-20-35-4B, and, for an indemnification asset that is not
subsequently measured at its fair value, management’s assessment of the
collectibility of the indemnification asset.
ASC Paragraph 805-20-35-4B (Before adoption of ASU 2016-13)1
An indemnification asset recognized at the acquisition date in accordance with
paragraphs 805-20-25-27 through 25-28 as a result of a government-assisted
acquisition of a financial institution involving an indemnification agreement shall
be subsequently measured on the same basis as the indemnified item. In certain
circumstances, the effect of the change in expected cash flows of the
indemnification agreement shall be amortized. Any amortization of changes in
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12. Subsequent Measurement and Accounting
value shall be limited to the lesser of the contractual term of the indemnification
agreement and the remaining life of the indemnified assets. For example, for
indemnified assets accounted for under paragraph 310-30-35-10, if the expected
cash flows on the indemnified assets increase (and there is no previously recorded
valuation allowance), an entity shall account for the associated decrease in the
indemnification asset by amortizing the change over the lesser of the contractual
term of the indemnification agreement and the remaining life of the indemnified
assets. Alternatively, if the expected cash flows on the indemnified assets increase
such that a previously recorded valuation allowance is reversed, an entity shall
account for the associated decrease in the indemnification asset immediately in
earnings. Any remaining decrease in the indemnification asset shall be amortized
over the lesser of the contractual term of the indemnification agreement and the
remaining life of the indemnified assets.
ASC Paragraph 805-20-35-4B (After adoption of ASU 2016-13)
An indemnification asset recognized at the acquisition date in accordance with
paragraphs 805-20-25-27 through 25-28 as a result of a government-assisted
acquisition of a financial institution involving an indemnification agreement shall
be subsequently measured on the same basis as the indemnified item. For
example, if the expected cash flows on indemnified assets increase such that a
previously recorded valuation allowance is reversed, an entity shall account for
the associated decrease in the indemnification assets immediately in earnings.
ASC Paragraph 805-20-40-3
The acquirer shall derecognize the indemnification asset recognized in accordance
with [ASC] paragraphs 805-20-25-27 through 25-28 only when it collects the
asset, sells it, or otherwise loses the right to it.
12.006 Indemnification assets are an exception to the recognition and measurement
principles of ASC Topic 805. An acquirer recognizes indemnification assets at the same
time and measures them on the same basis as the indemnified item, subject to any
contractual limitations on the amount of the indemnification and, for indemnification
assets not measured at fair value, the need for a valuation allowance for uncollectible
amounts. The acquirer would not recognize a valuation allowance for an indemnification
asset measured at fair value, because the collectibility considerations are reflected in the
measurement of fair value. An acquirer should not present indemnification assets as a
reduction of the associated liability, but rather should include them in assets in the
balance sheet. See the discussion of Indemnification Assets in Section 7.
12.007 Subsequent to initial recognition, the acquirer continues to measure an
indemnification asset recognized at the acquisition date on the same basis as the
indemnified asset or liability, subject to any contractual limitations on its amount and, for
an indemnification asset not subsequently measured at fair value, the need for a valuation
allowance for uncollectible amounts.
12.008 The initial and subsequent accounting for indemnification assets recognized at the
acquisition date also applies to assets and liabilities that are exceptions to the recognition
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12. Subsequent Measurement and Accounting
or measurement principles of ASC Topic 805. For example, an acquirer would initially
and continue to subsequently recognize and measure an indemnification asset related to a
liability from an uncertain tax position using assumptions consistent with those used to
measure the indemnified item (i.e., ASC Subtopic 740-10, Income Taxes - Overall).
12.009 ASC paragraphs 805-20-35-4 and 40-3 address the subsequent accounting for an
indemnification asset recognized at the acquisition date. However, as discussed in ASC
paragraphs 805-20-25-28, 30-18 through 30-19, indemnification may relate to an item not
recognized at the acquisition date. For example, an indemnification may relate to an
environmental contingency whose fair value is not determined at the acquisition date and
for which it is less than probable that a liability exists at the acquisition date in which
case an acquirer would not recognize the contingent liability at the acquisition date.
Because the related indemnified item was not initially recognized at the acquisition date,
the indemnified item is subsequently accounted for under other applicable GAAP,
including ASC Topic 450, as appropriate. Likewise, the indemnification asset is not
recognized at the acquisition date, and is subsequently accounted for under other
applicable GAAP, including ASC Topic 450, as appropriate. In these circumstances, we
also believe the indemnification asset should be recognized and measured at the same
time and on the same basis as the indemnified item, subject to any contractual limitations
on the amount of the indemnification and the need for a valuation allowance for
uncollectible amounts.
12.009a An acquisition agreement may require a portion of the consideration transferred
to be placed in an escrow account to allow the acquirer to make indemnification claims
against the former shareholders of the acquiree and retrieve the funds if the acquiree fails
to meet the terms of the agreement. If so, the funds placed into escrow are treated as part
of the consideration transferred, and the acquirer recognizes assumed contingencies and
related indemnification assets as described in Section 7. Funds released from the escrow
account to the acquirer would be recorded as a reduction in a related indemnification
asset, if any, or otherwise as a reduction to purchase consideration if they are released
because of facts and circumstances that existed as of the acquisition date. A release of
escrow to the acquirer related to anything other than a specific indemnification provided
in the purchase agreement (e.g., a dispute or litigation over false or misleading
representations) may need to be accounted for outside of the business combination (see
Paragraphs 12.033 and 12.034 for additional details). In addition, see Paragraph 6.020b
for discussion of consideration held in escrow for general representations and warranties.
12.010 Examples 12.2 through 12.3 illustrate the subsequent accounting for
indemnification assets that were initially recognized at the acquisition date (other than
those covered by ASC paragraph 805-20-35-4B). Example 12.4 illustrates the subsequent
accounting for indemnification assets covered by ASC paragraph 805-20-35-4B.
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12. Subsequent Measurement and Accounting
Example 12.2: Subsequent Accounting for Indemnification Asset When
Estimated Collectibility Changes
ABC Corp. has been fully indemnified for a liability arising from a contingency assumed
in the acquisition of DEF Corp. The liability recognized at the acquisition date was $10
million. Because of management’s collectibility assessment, ABC measured the
indemnification asset at the acquisition date at $9 million.
Subsequent to the acquisition, the carrying amount of the liability remains at $10 million.
However, the concerns about the collectibility of the indemnification asset no longer exist
(due to events following the acquisition).
Because there are no longer concerns about the collectibility of the indemnification asset,
ABC would reverse the valuation allowance. Because the change in estimated
collectibility resulted from events that occurred after the acquisition date, the change in
the valuation allowance would be recognized in earnings.
Example 12.3: Subsequent Accounting for an Indemnification Asset When
the Amount of the Related Indemnified Liability Decreases and the Fair
Value of the Assets Securing the Indemnification also Decreases
ABC Corp. was fully indemnified for a liability arising from a contingency that was
assumed in the acquisition of DEF Corp. The liability recognized at the acquisition date
was $10 million. ABC also recognized an indemnification asset of $10 million at the
acquisition date. The indemnification is secured by, and limited to, collateral held in
escrow, and the initial fair value of the collateral was $10 million.
Following the acquisition, ABC obtains new information and measures the liability at $6
million. The fair value of the escrowed assets (e.g., ABC shares included in the
consideration transferred for the acquisition of DEF) has subsequently declined to $4.5
million.
In this case, the liability would be measured at $6 million and ABC would reduce the
indemnification asset to $6 million. However, the carrying amount of the indemnification
asset would be reduced by a valuation allowance of $1.5 million, with a corresponding
charge against current earnings, due to the decline in fair value of the assets that
collateralize the indemnification.
DERECOGNITION OF INDEMNIFICATION ASSETS
12.011 Consistent with the derecognition of the related asset or liability recognized at the
acquisition date, ASC paragraphs 805-20-35-4 and 40-3 specify that the acquirer
derecognizes an indemnification asset only when it collects the asset, sells it, or otherwise
loses the right to it.
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12. Subsequent Measurement and Accounting
12.012 If the amounts recognized by an acquirer for an indemnified liability and a related
indemnification asset recognized at the acquisition date do not change subsequent to the
acquisition and are ultimately settled at the amounts recognized in the acquisition
accounting, there would be no effect on the statement of income. However, if either or
both of the recognized amounts change subsequent to the acquisition, either because of
new information or ultimate settlement, and the indemnified liability relates to an
expense, we believe there would be an effect on the income statement, even if both the
indemnified liability and the related indemnification asset change by equal and offsetting
amounts. In such situations, we believe the acquirer should present the effect on the
income statement on a gross, rather than a net basis.
12.013 For example, if an acquirer has been indemnified for losses from a specific
litigation matter, and a liability and an indemnification asset were recognized at the
acquisition date in the amount of $5 million, and both the liability and the
indemnification asset are subsequently increased to $9 million because new information
was obtained following the acquisition date, we believe the income statement generally
should be presented gross and reflect a $4 million charge related to the recognized
increase in the liability, and a $4 million credit related to the recognized increase in the
indemnification asset. Both the charge and the credit should be classified in accordance
with other applicable GAAP (e.g., ASC Section 220-20-45 and EITF Issue No. 01-10,
“Accounting for the Impact of the Terrorist Attacks of September 11, 2001”), which
could, in certain circumstances, be classified in the same income statement line item.
12.013a If either or both of the amounts recognized by an acquirer for an indemnified
liability and a related indemnification asset at the acquisition date change subsequent to
the acquisition, either because of new information or ultimate settlement, and the
indemnification relates to the cost of a capital asset, we believe the change would not be
recorded through the income statement given the indemnified item is a capital asset, and
there would be no expense in the absence of an indemnification arrangement.
12.013b For example, in 20X3, ABC Corp. acquired a business from XYZ Corp. The
property on which the business operates was subject to environmental review by the state.
In the purchase agreement, XYZ agreed to indemnify ABC for environmental
remediation costs exceeding $7 million. In 20X5, ABC received a final ruling from the
state that the environmental issue could be addressed by ABC constructing a new waste
water treatment plant on the site. ABC constructed the plant in 20X5 at a cost of $10
million, and submitted a claim to XYZ for reimbursement of $3 million. Upon meeting
the probable and reasonably estimable criteria for recognition in 20X5, ABC recorded the
cost of the waste water treatment plant asset of $7 million, an indemnification asset of $3
million and recognized the construction cost of $10 million. During 20X6, XYZ
challenged ABC's management of the construction costs and ABC agreed to settle for a
$2 million reimbursement. As a result, ABC increased its cost basis in the water
treatment plant by $1 million and decreased the indemnification asset by $1 million. We
believe no effect on the income statement (assuming there is no impairment of the related
asset) is recognized when the indemnified item is a capital asset, and there would be no
expense in the absence of an indemnification arrangement, only a higher cost basis in the
asset. Therefore, it is appropriate for any change to the measurement of the
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12. Subsequent Measurement and Accounting
indemnification asset, even when recorded subsequent to the measurement period, to be
offset against the cost basis in the capital asset with no income statement effect, as the
construction of a capital asset does not represent an expense. We believe this conclusion
is further supported by the principles described in paragraphs B301 to B303 of Statement
141R. In the guidance for indemnification assets, the Board made certain exceptions to
the acquisition date recognition and fair value measurement provisions of the accounting
for business combinations to permit entities to prevent recognition or measurement
anomalies.
12.014 Another example is the ultimate settlement of an indemnified tax uncertainty at an
amount other than the amount recognized at the acquisition date, as illustrated in
Example 12.4.
Example 12.4: Subsequent Settlement of an Indemnified Tax Uncertainty at
Less Than the Liability and Related Indemnification Asset Recognized at
the Acquisition Date
ABC Corp. acquired DEF Corp. in a business combination on April 30, 20X8. In
accounting for the acquisition, ABC recognized a $10 million liability at the acquisition
date related to an uncertain tax position of DEF, measured in accordance with FIN 48
(ASC Subtopic 740-10). ABC was fully indemnified for any liability resulting from the
ultimate resolution of the tax uncertainty, and there were no concerns about the
collectibility of the indemnification. Thus, ABC also recognized an indemnification asset
of $10 million at the acquisition date.
There were no changes in the amounts recognized by ABC with respect to either the
liability for the uncertain tax position or the indemnification asset until September 30,
20X9, when the liability for the uncertain tax position was effectively settled (ASC
paragraphs 740-10-25-10 through 25-11), with no payment being required by ABC (note
that for illustrative purposes, the accrual of interest and penalties, if any, related to the tax
uncertainty are ignored in this example). As a result, ABC derecognized the $10 million
liability it recognized at the acquisition date on September 30, 20X9, with an offsetting
credit to income tax expense in accordance with ASC Subtopic 740-10.
ABC also derecognized the indemnification asset of $10 million at September 30, 20X9.
However, the offsetting charge to the income statement would not be to income tax
expense, but rather would be classified as an expense based on other applicable GAAP.
DEFENSIVE INTANGIBLE ASSETS
ASC Paragraph 805-20-30-6
To protect its competitive position, or for other reasons, the acquirer may intend
not to use an acquired nonfinancial asset actively, or it may not intend to use the
asset according to its highest and best use. For example, that might be the case for
an acquired research and development intangible asset that the acquirer plans to
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12. Subsequent Measurement and Accounting
use defensively by preventing others from using it. Nevertheless, the acquirer
shall measure the fair value of the nonfinancial asset in accordance with [ASC]
Subtopic 820-10 assuming its highest and best use by market participants in
accordance with the appropriate valuation premise, both initially and for purposes
of subsequent impairment testing.
12.015 A business combination may result in the acquisition of assets that an entity does
not intend to actively use but does intend to prevent others from using. Such assets are
commonly referred to as defensive intangible assets or locked-up assets. In accordance
with ASC Topic 805, an acquirer would recognize and measure all intangible assets,
including defensive intangible assets, at fair value determined in accordance with ASC
Subtopic 820-10. This has led to questions as to how defensive intangible assets should
be accounted for subsequent to their acquisition. The EITF considered and reached a
consensus on this issue, which is contained in ASC paragraphs 350-30-15-15, 25-5, 35-
5A through 35-5B, 55-1, 55-1B, and 55-28H through 55-28L.
DEFENSIVE ASSETS USED IN IPR&D ACTIVITIES
12.016 The EITF’s conclusions require that intangible assets acquired in a business
combination that are used in research and development activities (regardless of whether
they have an alternative future use) are accounted for in accordance with ASC paragraph
350-30-35-17A, which provides that:
ASC Paragraph 350-30-35-17A
Intangible assets acquired in a business combination or an acquisition by a not-
for-profit entity that are used in research and development activities (regardless of
whether they have an alternative future use) shall be considered indefinite lived
until the completion or abandonment of the associated research and development
efforts. During the period those assets are considered indefinite lived they shall
not be amortized but shall be tested for impairment in accordance with [ASC]
paragraphs 350-30-35-18 through 35-19. Once the research and development
efforts are completed or abandoned, the entity shall determine the useful life of
the assets based on the guidance in [ASC] Section [350-30-35]. Consistent with
the guidance in [ASC] paragraph 360-10-35-49, intangible assets acquired in a
business combination or an acquisition by a not-for-profit entity that have been
temporarily idled shall not be accounted for as if abandoned.
12.017 Thus, when intangible IPR&D assets are acquired in a business combination, they
are considered to be indefinite lived until completion or abandonment of the associated
research and development efforts, and are not amortized during the period of
development. Additional research and development costs incurred subsequent to the
acquisition of the IPR&D asset are expensed as incurred, in accordance with ASC
Subtopic 730-10, Research and Development - Overall. Once the development effort is
completed, the useful life of the asset is determined based on the guidance in ASC
paragraph 350-30-35-3, and the IPR&D asset recognized in the acquisition accounting is
amortized over its estimated useful life. Additionally, the acquirer performs a final
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12. Subsequent Measurement and Accounting
impairment test under the indefinite-lived intangible asset model in accordance with ASC
paragraph 350-30-35-18 immediately prior to reclassifying the asset to definite-lived. If
the development effort is abandoned, and the IPR&D has no future alternative use, the
IPR&D asset is written off. During the development period, the IPR&D asset is tested for
impairment.
12.018 When an IPR&D asset is intended to be used for defensive purposes, the
accounting treatment will depend on what the acquired IPR&D asset is intended to
defend. For instance, if the IPR&D asset is acquired in a business combination to protect
an existing, ongoing R&D project of the acquirer, the acquired IPR&D asset should be
measured at its acquisition-date fair value and considered an indefinite-lived intangible
asset until the completion or abandonment of the existing R&D project of the acquirer.
Upon completion or abandonment of the acquirer’s existing R&D project, the IPR&D
asset’s useful life would be determined in accordance with the guidance in ASC
paragraph 350-30-35-3. Alternatively, if the IPR&D asset is acquired in a business
combination to defend an existing, completed product of the acquirer, and further
development of the acquired IPR&D asset is not planned, its useful life is determined,
and the asset would be amortized over that period, consistent with the guidance in ASC
paragraphs 350-30-35-6 through 35-13. The determination of the useful life of an IPR&D
asset to be used for defensive purposes will require the exercise of judgment. The
assumptions used in determining the useful life and the amortization methodology of an
IPR&D asset should be consistent with the assumptions used in determining its fair value.
See the discussion of the determination of fair value of IPR&D assets in Section 17.
OTHER DEFENSIVE INTANGIBLE ASSETS
12.019 ASC Subtopic 350-30 provides the following guidance for defensive intangible
assets:
• The determination of whether an acquired intangible is a defensive intangible
asset is based on the intentions of the acquirer. That determination may
change as the acquirer’s intentions change. For example, an intangible asset
that was accounted for as a defensive intangible asset on the acquisition date
will cease to be a defensive asset if the acquirer subsequently decides to
actively use the asset.
• A defensive intangible asset should be accounted for as a separate unit of
accounting. It should not be included as part of the acquirer’s cost of an
existing intangible asset, because the defensive intangible asset is separately
identifiable.
• A defensive intangible asset should be assigned a useful life in accordance
with ASC paragraphs 350-30-35-3. The useful life should reflect the
acquirer’s consumption of the expected benefits related to that asset (i.e., the
benefit a reporting entity receives from holding a defensive intangible asset in
the form of direct and indirect cash flows resulting from the prevention of
others from realizing any value from the intangible asset (defensively or
otherwise).
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•
•
It would be rare for a defensive intangible asset to have an indefinite life
because the fair value of the defensive intangible asset will generally diminish
over time as a result of a lack of market exposure or as a result of competitive
or other factors.
If an intangible asset meets the definition of a defensive intangible asset, it
cannot be considered immediately abandoned.
12.020 The following example, taken from ASC paragraph 350-30-55-28H, illustrates the
determination of whether an intangible asset is within its scope.
Example 12.5: Acquired Trade Name the Acquirer Intends to Hold for
Defensive Purposes
ABC Corp., a consumer products manufacturer, acquires an entity that sells a product that
competes with one of ABC’s existing products. ABC plans to discontinue the sale of the
competing product within the next six months, but will maintain the rights to the trade
name, at minimal expected cost, to prevent a competitor from using the trade name. As a
result, ABC’s existing product is expected to experience an increase in market share.
ABC does not have any current plans to reintroduce the acquired trade name in the future.
Analysis. Because ABC does not intend to actively use the acquired trade name, but
intends to hold the rights to the trade name to prevent others from using it, the trade name
meets the definition of a defensive intangible asset.
CONTINGENT CONSIDERATION
ASC Paragraph 805-30-35-1
Some changes in the fair value of contingent consideration that the acquirer
recognizes after the acquisition date may be the result of additional information
about facts and circumstances that existed at the acquisition date that the acquirer
obtained after that date. Such changes are measurement period adjustments in
accordance with [ASC] paragraphs 805-10-25-13 through 25-18 and [ASC]
Section 805-10-30. However, changes resulting from events after the acquisition
date, such as meeting an earnings target, reaching a specified share price, or
reaching a milestone on a research and development project, are not measurement
period adjustments. The acquirer shall account for changes in the fair value of
contingent consideration that are not measurement period adjustments as follows:
a. Contingent consideration classified as equity shall not be remeasured and
its subsequent settlement shall be accounted for within equity.
b. Contingent consideration classified as an asset or a liability shall be
remeasured to fair value at each reporting date until the contingency is
resolved. The changes in fair value shall be recognized in earnings unless the
arrangement is a hedging instrument for which [ASC] Topic 815 requires the
changes to be initially recognized in other comprehensive income.
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12. Subsequent Measurement and Accounting
ASC Paragraph 805-30-35-1A
Contingent consideration arrangements of an acquiree assumed by the acquirer in
a business combination shall be measured subsequently in accordance with the
guidance for contingent consideration arrangements in [ASC paragraph 805-30-
35-1].
12.021 Contingent consideration is initially recognized by an acquirer at the acquisition
date as part of the consideration transferred, measured at its acquisition-date fair value.
See the discussion of Contingent Consideration in Section 6, and the discussion of
determining the fair value of contingent consideration issued in a business combination in
Section 18.
12.022 Changes in the fair value of contingent consideration initially recognized that
result from additional information about facts and circumstances that existed at the
acquisition date that the acquirer obtains during the measurement period are measurement
period adjustments. Those changes are recognized as adjustments to the amount
provisionally recognized as of the acquisition date, and therefore are adjustments to the
acquisition accounting. See the discussion of Adjustments to Provisional Amounts during
the Measurement Period in Section 10.
12.022a Contingent consideration arrangements could be altered in certain instances,
such as disputes over the terms of the arrangement or changes in the terms. We believe
that any adjustment due to disputes over the terms of a contingent consideration
arrangement should be recognized in current earnings, unless there is a clear and direct
link to the consideration transferred based on facts and circumstances that existed as of
the acquisition date. If a clear and direct link is established between the dispute and the
amount of consideration transferred, the consideration transferred is adjusted. See
discussion of clear and direct link at Paragraph 12.033. Any additional consideration
transferred to the selling shareholders due to litigation over the value of the consideration
transferred should be expensed unless the settlement occurs during the measurement
period and meets the clear and direct link criteria. Any post-acquisition change to the
contingent consideration terms is accounted for separately from the business
combination.
SUBSEQUENT MEASUREMENT OF CONTINGENT CONSIDERATION
12.023 The accounting for changes in fair value of contingent consideration after the
acquisition date, other than measurement period adjustments, depends on whether the
contingent consideration is classified as equity (equity-classified) or a liability (liability-
classified). The classification is reassessed at each reporting period. Contingent
consideration classified as equity is not remeasured and its subsequent settlement is
accounted for within equity. Contingent consideration that is liability-classified (or in
some instances asset-classified), including pre-existing contingent consideration
arrangements of the acquiree, is remeasured to fair value at each reporting date until the
contingency is resolved. We believe that changes in fair value are generally recognized in
operating income (expense) when such a caption is presented (otherwise recorded in
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12. Subsequent Measurement and Accounting
earnings), unless the arrangement is a hedging instrument in a cash flow hedge for which
ASC Topic 815 requires the changes to be initially recognized in other comprehensive
income. For guidance on presenting contingent consideration in the statement of cash
flows, see chapter 18 of KPMG Handbook, Statement of cash flows.
Subsequent Measurement of Equity-Classified Contingent Consideration
12.024 An acquirer does not remeasure contingent consideration classified as equity and
its subsequent settlement is accounted for within equity. Each reporting period, the
acquirer reassesses the classification of contingent consideration based on the
classification of the underlying instrument. Along with the other criteria in ASC Section
815-40-25, an instrument continues to be equity classified if:
(a) Currently authorized, but unissued shares less the maximum number of shares
that could be required to settle the existing commitments that may require the
issuance of stock during the length of the contingent consideration are greater
than the
(b) Maximum number of shares required to be delivered under the contingent
consideration.
If these criteria are no longer met by the underlying instrument, the contingent
consideration is remeasured at fair value with the change recognized as an adjustment to
stockholders' equity and the underlying instrument is reclassified to a liability.
Subsequent Measurement of Liability-Classified Contingent Consideration
12.025 The FASB concluded that an acquirer should account for all liabilities for
contingent payments (including contingent consideration) similarly, and should
remeasure such liabilities at fair value after the acquisition date until settled. An acquirer
recognizes such changes in fair value in earnings as they occur (unless the changes result
from measurement period adjustments, or the contingent consideration has been used as a
hedging instrument in a cash flow hedge as discussed in Paragraph 12.023). An acquirer
should classify changes in fair value resulting from (1) the passage of time (i.e., accretion
expense) and (2) revisions to the amount or timing of the initial measurement of the
contingent consideration as an operating item in the income statement. This classification
guidance is also consistent with ASC paragraph 410-20-35-5, which addresses financial
accounting and reporting of liabilities associated with asset retirement obligations.
12.026 Many obligations for contingent consideration that qualify for classification as
liabilities meet the definition of a derivative instrument in ASC Topic 815, Derivatives
and Hedging. However, before issuance of ASC Topic 805, contingent consideration
issued in a business combination was excluded from the scope of ASC Topic 815. In
deliberating ASC Topic 805, the FASB concluded that all contracts that would otherwise
be within the scope of ASC Topic 815 (if not issued in a business combination) should be
subject to the requirements of ASC Topic 815. As a result, liabilities for contingent
consideration arising from a business combination that are subject to the requirements of
ASC Topic 815, are subsequently measured at fair value, with changes in fair value
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12. Subsequent Measurement and Accounting
recognized in earnings, unless the arrangement is a hedging instrument in a cash flow
hedge for which ASC Topic 815 requires the changes to be initially recognized in other
comprehensive income. We are not aware of situations where contingent consideration
has been used as a hedging instrument, and expect that any situations where this might
apply will be rare.
12.026a The classification of contingent consideration is reassessed each reporting period
to assess potential changes to the classification of the underlying instrument. On the date
the underlying instrument is reclassified to equity, the contingent consideration is
remeasured at fair value with the gain or loss recognized in earnings immediately before
the underlying instrument is reclassified to equity. Previously recorded fair value
adjustments on liability classified contingent consideration are not reversed.
Example 12.5a: Attribution of Changes in a Contingent Consideration
Liability to a Noncontrolling Interest
ABC purchased a 70% controlling interest in Entity X in a business combination for an
initial cash payment of $1,000 plus $500 to be paid to Seller on the achievement of a
future research and development milestone. Assume the contingent payment is
liability-classified contingent consideration with an acquisition date fair value of $400
and that the fair value of the noncontrolling interest (NCI) is $600 (for simplicity
disregard the effects of any control premium). At the date of acquisition ABC records
the following:
Net assets
2,000
Cash
Contingent consideration liability
NCI
1,000
400
600
In the period following the acquisition, the milestone is achieved and ABC pays $500
to Seller. ABC records the following:
Contingent consideration liability
Operating expense
Cash
400
100
500
As the contingent consideration relates to the agreement between ABC and Seller
rather than the income (loss) of Entity X, none of the expense related to the change in
the liability would be attributed to the noncontrolling interest (i.e., it is entirely
attributed to the parent). See Chapter 15, Noncontrolling Interests in Consolidated
Financial Statements, for further details on attributing net income or loss between the
parent and NCI.
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12. Subsequent Measurement and Accounting
CONTINGENTLY ISSUABLE DEBT
12.027 An acquisition agreement in a business combination may provide for the issuance
of additional consideration in the form of notes, with interest payable during the
contingency period to an escrow agent who holds the notes. ASC Topic 805 requires that
an acquirer initially measure and recognize all contingent consideration, including
contingently issuable debt, at its acquisition-date fair value and include the amount so
determined in the consideration transferred to effect the acquisition. The initial fair value
measurement would include consideration of all appropriate information, including any
difference between the stated rate and market rate of interest on the contingently issuable
debt. Because the note instruments would be liability-classified contingent consideration,
an acquirer would remeasure the notes to fair value at each reporting date until the
contingency is resolved, and recognize the changes in fair value in earnings. Such
increases or decreases would include the effect of the accrual of interest and all other
changes affecting the fair value measurement, including (but not limited to) any changes
in fair value arising from changes in the appropriate market interest rate and changes in
the estimate of the amount of the contingently issuable consideration that will ultimately
be issued.
12.028 An acquirer may also be obligated to make payments of interest on the
contingently issuable debt into an escrow account. In those situations, an intangible asset
(or liability) would be recognized at the acquisition date, in an amount equal to the fair
value derived from the difference, if any, between the interest rate that will be earned on
the amounts paid into escrow and the interest rate a market participant would expect to
earn on the amounts paid into escrow during the period of the contingency. The
intangible asset (or liability) would be accreted to interest income such that, along with
the interest earned on the escrowed funds, the acquirer would recognize interest income
on the escrowed funds at the market rate determined as of the acquisition date. Amounts
paid into escrow, and any interest earned thereon, would be recognized by the acquirer as
a deposit throughout the period of the contingency and would ultimately be eliminated
when the amount in escrow is either transferred to the seller as a part of payment of the
recognized liability for the contingently issuable debt or returned to the acquirer in cash.
OTHER APPLICABLE GAAP
12.029 As previously noted, an acquirer would subsequently account for most of the
assets acquired, liabilities assumed or incurred, and equity instruments issued in an
acquisition, in accordance with other applicable GAAP. ASC paragraphs 805-20-35-5,
35-7, 35-8 and 805-30-35-2 and 35-3 provide the following examples of other relevant
GAAP that provide guidance on subsequently measuring and accounting for assets
acquired and liabilities assumed or incurred in a business combination:
(a) ASC paragraph 350-30-15-4 prescribes the accounting for goodwill and
identifiable intangible assets acquired in a business combination, including:
(1) Recognition of intangible assets used in research and development
activities, regardless of whether those assets have an alternative future use
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12. Subsequent Measurement and Accounting
(2) Classification of research and development intangible assets as indefinite-
lived until the completion or abandonment of the associated research and
development efforts.
(b) ASC Topic 944, Financial Services—Insurance, provides guidance on the
subsequent accounting for an insurance or reinsurance contract acquired in a
business combination.
(c) ASC Topic 740 prescribes the subsequent accounting for deferred tax assets
(including valuation allowances) and liabilities acquired in a business
combination.
(d) ASC Topic 718 provides guidance on subsequent measurement and
accounting for the portion of replacement share-based payment awards issued
by an acquirer that is attributable to grantees' future services.
(e) ASC Topic 810 provides guidance on accounting for changes in a parent’s
ownership interest in a subsidiary after control is obtained.
Example 12.5b: Subsequent Accounting for a Liability for an Unfavorable
Executory (Revenue) Contract
The following facts apply to all 4 scenarios presented below.
ABC Company (ABC) acquires XYZ Corporation in a business combination. Before the
acquisition, XYZ entered into a non-cancellable executory contract with a customer to
supply parts at fixed prices. At the time of the acquisition by ABC, the rates were below
market (i.e., ABC assumed an unfavorable contract). ABC recognized a liability on the
balance sheet for the below market component of the contract.
Note: The conclusions below apply regardless of whether ABC has adopted ASC Topic
606, Revenue from Contracts with Customers. See discussion of the effect of ASC Topic
606 adoption on an acquirer's accounting for a business combination beginning at
Paragraph 17.084a.
Scenario 1
The contract requires delivery of a fixed number of parts. Subsequent to the acquisition
of XYZ, ABC and the customer modify the contract to reduce the number of parts ABC
will deliver under the contract.
ABC should account for the change prospectively as a change in estimate. ABC should
revise its per-part allocation of the liability at the date of the modification by dividing the
remaining balance over the revised number of parts to be delivered at the date of the
modification. It would not be appropriate for ABC to make a one-time adjustment to
reduce the liability as a result of the change in the number of units to be delivered.
Scenario 2
The contract does not specify the number of parts to be delivered. At the date of the XYZ
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12. Subsequent Measurement and Accounting
acquisition, ABC expected XYZ to deliver 80,000 parts over the remainder of the
contract. Subsequent to the acquisition, the customer notifies ABC that it will order only
10,000 more parts because it plans to discontinue the product of which XYZ's parts are a
component.
Similar to Scenario 1, ABC should account for the change in the estimate of the number
of parts to be delivered prospectively by reallocating the remaining liability balance to
the remaining parts. ABC should not derecognize a portion of the liability to retain its
original estimated per-part allocation of the liability.
Scenario 3
As a result of cost reductions from synergies with its own operations, the contract
becomes more profitable to ABC.
The cost savings realized after the acquisition are an economic event that occurred after
the acquisition, and therefore ABC should not adjust the liability as a result of this event.
ABC continues to allocate the liability for the unfavorable contract to the parts based on
its original allocation.
Scenario 4
Subsequent to ABC's acquisition of XYZ, the selling prices of similar parts in the
marketplace have decreased, such that the contract is now priced at market and no longer
unfavorable to ABC.
Similar to Scenario 3, the increase in market price is an economic event that occurred
after the acquisition, and therefore ABC should not adjust the liability as a result of this
event. ABC continues to allocate the liability for the unfavorable contract to the
remaining parts based on its original allocation.
CONSISTENCY OF ACCOUNTING POLICIES
12.030 Accounting policies of the acquiree should be conformed to those of the acquirer
after a business combination. Dissimilar operations, assets, or transactions may be a basis
for different accounting policies. Alternatively, the acquirer may change its accounting
policies to conform to those of the acquiree, which would be considered a change in
accounting principle, permitted only if the acquirer can justify use of an allowable
alternative accounting principle that is preferable under ASC Subtopic 250-10,
Accounting Changes and Error Corrections - Overall. If the accounting acquirer does not
have an established policy in relation to the asset acquired or liability assumed, in our
view, the acquirer and acquiree can apply any accounting policy that is acceptable under
U.S. GAAP, including one that is different from what the acquiree had applied. In this
scenario, the acquirer would not need to consider whether the accounting policy is
preferable as compared to the accounting policy previously applied by the acquiree.
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ERROR DISCOVERED AFTER A BUSINESS COMBINATION
12.031 Material errors in the acquiree’s financial statements may be discovered
subsequent to a business combination. In some situations, if the acquirer had known
about the errors at the time of the acquisition, it would have affected the consideration
transferred (e.g., where the consideration was determined based on the acquiree’s
precombination financial statements). However, if the consideration would have changed
but there is no actual adjustment of the consideration paid by the buyer to the seller as a
result of the subsequent identification of the error, there can be no adjustment to the
acquisition accounting. Therefore, any change in assets or liabilities resulting from the
correction of the error would be recognized in earnings in the acquirer’s postcombination
financial statements. Alternatively, if it is determined that the nature of the errors
discovered would not have affected the consideration transferred, the adjustment would
generally be recorded to goodwill.
12.032 These scenarios described in the preceding paragraph are presented in the
following decision tree.
Example 12.6: Subsequent Discovery of Errors in Acquiree’s Financial
Statements
Scenario 1. Company A acquires Target for $100 million on October 31, 20X0. The
acquisition agreement provides for a working capital adjustment with a provision for
arbitration in the event of a dispute. Four months after the acquisition, Company A
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12. Subsequent Measurement and Accounting
determines that Target has failed to accrue a $10 million liability owed to a regulatory
authority. This liability was not discovered during Company A’s due diligence process.
Company A believes that the definition of a liability was met at the acquisition date. The
former owner of Target (Seller) refuses to reimburse Company A for the liability and the
amount is in dispute. The dispute will be resolved through arbitration per the acquisition
agreement.
Company A would record the liability with the corresponding debit to expense rather
than to goodwill. The amount in dispute does not represent an asset to Company A.
Because Company A would have adjusted the consideration paid had it known about the
liability, it cannot record the debit as goodwill even though the amount was discovered
during the measurement period. Stated differently, had Company A known about the
liability, it would have paid less for Target resulting in the same amount of goodwill as is
currently recorded (in essence, the reduction of the consideration paid would have been
offset by the liability). The fact that the agreement provided for a working capital
adjustment does not automatically mean that an adjustment to goodwill is appropriate. If
both parties had agreed to an adjustment to working capital, Company A would have
recorded a receivable from Seller rather than an adjustment to goodwill. In this example,
if Company A were to record the debit as a receivable, it likely would need to record a
full valuation allowance through earnings because the amount is in dispute. If Company
A subsequently receives a settlement from Seller when the dispute is resolved, the
amount would be recorded as a gain in the income statement through the same line item
as the expense was recorded in the earlier period.
Scenario 2. DEF Corp. acquires Target in a business combination. The terms of the
acquisition agreement require DEF to pay $200 million and do not address potential
adjustments to the consideration related to Target’s working capital. After finalizing
Target’s acquisition-date balances, DEF identified an inventory cut-off error that existed
at the acquisition date and resulted in a $3 million overstatement of inventory. DEF can
demonstrate that the acquisition of Target was important to its future strategic plans and
the consideration would have been $200 million regardless of the amount of working
capital of Target on the acquisition date. DEF has not filed a claim against Seller for the
difference in balances.
DEF should record the adjustment to reduce inventory as an increase to goodwill.
12.033 With respect to litigation over the purchase price, an SEC staff speech noted that
contingencies that arise from the dispute and related litigation are not preacquisition
contingencies that would be recognized in the acquisition accounting. The staff has only
accepted settlement of the litigation over the purchase price as being an adjustment to the
consideration transferred in situations where there is a clear and direct link to the
consideration transferred such as when the litigation is seeking enforcement of an escrow
arrangement that specifies a minimum amount of working capital in the acquired
business, which may establish a clear and direct link to the consideration transferred.
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12. Subsequent Measurement and Accounting
12.034 Often the litigation is complicated by claims involving misrepresentation and
other assertions by the claimants. In such cases, the acquirer would need to be able to
persuasively demonstrate that all or a specifically identified portion of the mixed claim is
clearly and directly linked to the consideration transferred otherwise, subsequent
adjustments would be recognized in current earnings. The SEC staff speech notes that in
situations where the initial determination of the fair value of the acquired assets and
liabilities is incorrect (such as the situation in Scenario 1 above) any adjustment generally
would not be reflected as an adjustment to the acquisition accounting. Similarly, claims
that one party mislead the other or disputes about the meaning of certain language in the
acquisition agreement are not unique to business combinations and therefore such
settlements normally would be recognized in current earnings.
Example 12.7: Litigation with Dissenting Shareholders
Company A, a private-equity firm, acquired Target on September 30, 20X0 for $2 billion
in cash, or $167 a share, and simultaneously took Target private. A minority number of
Target’s shareholders dissented to the acquisition and brought litigation against Company
A to obtain additional consideration for their shares in Target. Under the applicable state
law, court judgments of fair value are subject to interest at 5% above the Federal Reserve
discount rate of 1.75%, which accrues from the date of the merger through the date of
payment of the judgment.
On November 30, 20X0, the court ruled in favor of the dissenting shareholders and
awarded them $170 per share. Company A paid this amount on December 15, 20X0, plus
interest of $2 per share in accordance with state law. Although one may view the
incremental consideration as an additional cost in acquiring Target, the SEC staff has
taken the position that the additional consideration of $3 per share ($170 - $167) paid to
the dissenting former shareholders of Target is an expense in Company A’s
postcombination financial statements. Additionally, the related interest of $2 per share
paid on December 15, 20X0 is also charged as an expense in Company A’s
postcombination financial statements. Associated legal costs are charged to expense by
Company A as incurred.
1 ASU 2016-13, Measurement of Credit Losses on Financial Instruments, is effective for public business
entities that are SEC filers, excluding entities eligible to be smaller reporting companies as defined by the
SEC, for annual and interim periods in fiscal years beginning after December 15, 2019. The one-time
determination of whether an entity is eligible to be a smaller reporting company shall be based on an
entity’s most recent determination as of November 15, 2019, in accordance with SEC regulations.
For all other entities, it is effective for annual and interim periods in fiscal years beginning after December
15, 2022. Early adoption is permitted for annual and interim periods in fiscal years beginning after
December 15, 2018.
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Section 13 - Disclosures
Detailed Contents
Business Combinations Completed during the Reporting Period, or after the Reporting
Period but before Issuance of the Acquirer's Financial Statements
General Information about the Acquisition Transaction
Consideration Transferred
Contingent Consideration Arrangements and Indemnification Assets
Certain Acquired Receivables
Assets Acquired and Liabilities Assumed
Goodwill
Bargain Purchases
Equity Interest Not Acquired (Noncontrolling Interest)
Business Combination Achieved in Stages (Step Acquisitions)
Separately Accounted for Transactions, Including Preexisting Relationships
Additional Disclosures for Public Entities
Impracticability
Acquiree Revenue and Earnings Since Acquisition
Supplemental Pro Forma Information
Interim Period Pro Forma Information
Q&A 13.1: Pro Forma Disclosures in Interim Periods
Pro Forma Information Required to be Presented in Filings with the SEC
Immaterial Business Combinations That Are Material in the Aggregate
Business Combinations Completed after Reporting Date but before Issuance of the
Financial Statements
Disclosure of Adjustments Recognized during the Current Period
Measurement Period Adjustments
Contingent Consideration Adjustments
Reconciliation of Changes in Goodwill during the Reporting Period
Additional Disclosures to Meet Disclosure Objectives
Example Disclosures
Example 13.1: Disclosure of a Material Business Combination in the Year of
Acquisition, Completed During the Reporting Period
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13. Disclosures
13.000 ASC Topic 805, Business Combinations, outlines the acquirer’s disclosure
requirements in the context of two overall objectives, which are set out in ASC
paragraphs 805-10-50-1 and 50-5. Disclosures should enable financial statement users to
evaluate:
(1) The nature and financial effect of a business combination that occurs either
during the current reporting period, or after the reporting date but before the
financial statements are issued or are available to be issued (determined in
accordance with ASC Section 855-10-25); and
(2) The financial effects of adjustments recognized in the current reporting period
that relate to business combinations that occurred in the current or previous
reporting periods.
13.001 ASC paragraphs 805-10-50-2, 805-20-50-1, 50-4, 50-4A, and 50-5, 805-30-50-1
and 50-4 include a number of specific disclosure requirements, consistent with these
objectives. However, if the disclosures required by ASC paragraphs 805-10-50-2 and 50-
6 do not satisfy the overall disclosure objectives of ASC paragraphs 805-10-50-1 and 50-
4, ASC paragraph 805-10-50-7 requires the acquirer to disclose whatever additional
information is necessary to meet those objectives.
13.002 The disclosures are required for each material business combination during the
periods presented. We believe this includes prior periods presented for comparative
purposes. For individually immaterial business combinations that are material
collectively, the disclosures required by ASC paragraphs 805-10-50-2(e) through 50-2(h),
805-20-50-1(a) through 50-1(e) and 805-30-50-1(a) through 50-1(f) are required in the
aggregate. For business combinations occurring after the reporting date but before the
financial statements of the acquirer are issued, the disclosures in ASC paragraph 805-10-
50-2 are required unless the initial accounting for the business combination is incomplete
at the date of issuance of the acquirer’s financial statements. In such event, the acquirer is
required to disclose the disclosures that could not be made, including the reason they
could not be made.
13.003 Additionally, ASC paragraphs 270-10-50-5 and 50-7a note that the disclosure
requirements of ASC Topic 805 are applicable to interim financial information.
13.004 Many of the disclosure requirements are illustrated in an example presented in
ASC paragraphs 805-10-55-37 through 55-49. The disclosures presented are referenced
to the specific disclosure requirements of ASC paragraph 805-10-50-4 that they illustrate.
The entire example from ASC paragraphs 805-10-55-37 through 55-49 is presented in
Paragraph 13.035.
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13. Disclosures
BUSINESS COMBINATIONS COMPLETED DURING THE
REPORTING PERIOD, OR AFTER THE REPORTING PERIOD BUT
BEFORE ISSUANCE OF THE ACQUIRER'S FINANCIAL
STATEMENTS
ASC Paragraph 805-10-50-1
The acquirer shall disclose information that enables users of its financial
statements to evaluate the nature and financial effect of a business combination
that occurs either:
a. During the current reporting period
b. After the reporting date but before the financial statements are issued or are
available to be issued (as discussed in [ASC] Section 855-10-25).
ASC Paragraph 805-10-50-2
To meet the objective in [ASC paragraph 805-10-50-1], the acquirer shall disclose
the following information for each business combination that occurs during the
reporting period: …[Information discussed below]
GENERAL INFORMATION ABOUT THE ACQUISITION TRANSACTION
ASC Paragraph 805-10-50-2(a) through 50-2(d)
a. The name and a description of the acquiree
b. The acquisition date
c. The percentage of voting equity interests acquired
d. The primary reasons for the business combination and a description of how the
acquirer obtained control of the acquiree
CONSIDERATION TRANSFERRED
ASC Paragraph 805-30-50-1(b)
b. The acquisition-date fair value of the total consideration transferred and the
acquisition-date fair value of each major class of consideration, such as the
following:
1. Cash
2. Other tangible or intangible assets, including a business or subsidiary of the
acquirer
3. Liabilities incurred, for example, a liability for contingent consideration
4. Equity interests of the acquirer, including the number of instruments or
interests issued or issuable and the method of determining the fair value of
those instruments or interests.
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13. Disclosures
CONTINGENT CONSIDERATION ARRANGEMENTS AND INDEMNIFICATION
ASSETS
ASC Paragraph 805-30-50-1(c)
c. For contingent consideration arrangements, all of the following:
1. The amount recognized as of the acquisition date
2. A description of the arrangement and the basis for determining the amount
of the payment
3. An estimate of the range of outcomes (undiscounted) or, if a range cannot
be estimated, that fact and the reasons why a range cannot be estimated. If the
maximum amount of the payment is unlimited, the acquirer shall disclose that
fact.
ASC Paragraph 805-20-50-1(a)
a. For indemnification assets, all of the following:
1. The amount recognized as of the acquisition date
2. A description of the arrangement and the basis for determining the amount
of the payment
3. An estimate of the range of outcomes (undiscounted) or, if a range cannot
be estimated, that fact and the reasons why a range cannot be estimated. If the
maximum amount of the payment is unlimited, the acquirer shall disclose that
fact.
CERTAIN ACQUIRED RECEIVABLES
ASC Paragraph 805-20-50-1(b)
b. For acquired receivables not subject to the requirements of [ASC] Subtopic
310-30 [Receivables - Loans and Debt Securities Acquired with Deteriorated
Credit Quality] (Subtopic 326-20 [Receivables - Credit Losses—Measured at
Amortized Cost] relating to purchased financial assets with credit deterioration
after the adoption of ASU 2016-131), all of the following:
1. The fair value of the receivables
2. The gross contractual amounts receivable
3. The best estimate at the acquisition date of the contractual cash flows not
expected to be collected.
(Before the adoption of ASU 2016-02, Leases2) The disclosures shall be provided
by major class of receivable, such as loans, direct finance leases in accordance
with [ASC] Subtopic 840-30, and any other class of receivables.
(After the adoption of ASU 2016-02, Leases3) The disclosures shall be provided
by major class of receivable, such as loans, net investment in sales-type or direct
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13. Disclosures
financing leases in accordance with [ASC] Subtopic 842-30 on leaseslessor,
and any other class of receivables.
13.005 The above disclosure requirements about receivables acquired was developed to
help in assessing considerations of credit quality included in the fair value measures to
address concerns that without additional disclosures, it would be impossible to determine
the contractual cash flows and the amount of the contractual cash flows not expected to
be collected if receivables were recognized at fair value. Statement 141(R), par. B258
ASSETS ACQUIRED AND LIABILITIES ASSUMED
ASC Paragraph 805-20-50-1(c) and 50-1(d)
c. The amounts recognized as of the acquisition date for each major class of assets
acquired and liabilities assumed (see Example 5 [ASC paragraph 805-10-55-37]).
d. For contingencies, the following disclosures shall be included in the note that
describes the business combination:
1. For assets and liabilities arising from contingencies recognized at the
acquisition date:
i. The amounts recognized at the acquisition date and the measurement
basis applied (that is, at fair value or at an amount recognized in
accordance with [ASC] Topic 450 and [ASC] Section 450-20-25)
ii. The nature of the contingencies.
An acquirer may aggregate disclosures for assets and liabilities arising from
contingencies that are similar in nature.
2. For contingencies that are not recognized at the acquisition date, the
disclosures required by [ASC] Topic 450 if the criteria for disclosures in that
Topic are met.
An acquirer may aggregate disclosures for assets and liabilities arising from
contingencies that are similar in nature.
GOODWILL
ASC Paragraph 805-30-50-1(a), 50-1(d), and 50-1(e)
a. A qualitative description of the factors that make up the goodwill recognized,
such as expected synergies from combining operations of the acquiree and the
acquirer, intangible assets that do not qualify for separate recognition, or other
factors.
d. The total amount of goodwill that is expected to be deductible for tax purposes.
e. If the acquirer is required to disclose segment information in accordance with
[ASC] Subtopic 280-10 [Segment Reporting - Overall], the amount of goodwill
by reportable segment. If the assignment of goodwill to reporting units required
by [ASC] paragraphs 350-20-35-41 through 35-44 has not been completed as of
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13. Disclosures
the date the financial statements are issued or are available to issued (as discussed
in [ASC] Section 855-10-25), the acquirer shall disclose that fact.
BARGAIN PURCHASES
ASC Paragraph 805-30-50-1(f)
f. In a bargain purchase (see [ASC] paragraphs 805-30-25-2 through 25-4), both
of the following:
1. The amount of any gain recognized in accordance with [ASC] paragraph
805-30-25-2 and the line item in the income statement in which the gain is
recognized
2. A description of the reasons why the transaction resulted in a gain.
EQUITY INTEREST NOT ACQUIRED (NONCONTROLLING INTEREST)
ASC Paragraph 805-20-50-1(e)
e. For each business combination in which the acquirer holds less than 100
percent of the equity interests in the acquiree at the acquisition date, both of the
following:
1. The fair value of the noncontrolling interest in the acquiree at the
acquisition date
2. The valuation technique(s) and significant inputs used to measure the fair
value of the noncontrolling interest.
BUSINESS COMBINATION ACHIEVED IN STAGES (STEP ACQUISITIONS)
ASC Paragraph 805-10-50-2(g)
g. In a business combination achieved in stages, all of the following:
1. The acquisition-date fair value of the equity interest in the acquiree held by
the acquirer immediately before the acquisition date
2. The amount of any gain or loss recognized as a result of remeasuring to fair
value the equity interest in the acquiree held by the acquirer immediately
before the business combination (see [ASC] paragraph 805-10-25-10) and the
line item in the income statement in which that gain or loss is recognized
3. The valuation technique(s) used to measure the acquisition-date fair value
of the equity interest in the acquiree held by the acquirer immediately before
the business combination
4. Information that enables users of the acquirer’s financial statements to
assess the inputs used to develop the fair value measurement of the equity
interest in the acquiree held by the acquirer immediately before the business
combination.
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13. Disclosures
SEPARATELY ACCOUNTED FOR TRANSACTIONS, INCLUDING PREEXISTING
RELATIONSHIPS
ASC Paragraph 805-10-50-2(e) and 50-2(f)
e. For transactions that are recognized separately from the acquisition of assets
and assumptions of liabilities in the business combination (see [ASC] paragraph
805-10-25-20), all of the following:
1. A description of each transaction
2. How the acquirer accounted for each transaction
3. The amounts recognized for each transaction and the line item in the
financial statements in which each amount is recognized
4. If the transaction is the effective settlement of a preexisting relationship, the
method used to determine the settlement amount.
f. The disclosure of separately recognized transactions required in [ASC
paragraph 805-10-50-2](e) shall include the amount of acquisition-related costs,
the amount recognized as an expense, and the line item or items in the income
statement in which those expenses are recognized. The amount of any issuance
costs not recognized as an expense and how they were recognized also shall be
disclosed.
ADDITIONAL DISCLOSURES FOR PUBLIC ENTITIES
13.006 ASC paragraph 805-10-50-2(h) requires additional disclosures for entities that
meet the definition of a public entity as described in ASC Section 805-10-20:
A business entity or not-for-profit entity that meets any of the following
conditions:
a. It has issued debt or equity securities or is a conduit bond obligor for
conduit debt securities that are traded in a public market (a domestic or
foreign stock exchange or an over-the-counter market, including local or
regional markets).
b. It is required to file financial statements with the Securities and Exchange
Commission (SEC).
c. It provides financial statements for the purpose of issuing any class of
securities in a public market.
The additional disclosure requirements apply only to a public entity's financial
statements, not to the financial statements of a subsidiary of a public entity. For example,
if a subsidiary of a public entity acquires another entity in a business combination, the
disclosure requirements in ASC paragraph 805-10-50-2(h) do not apply to the acquiring
subsidiary's stand-alone financial statements if that subsidiary is not itself a public entity.
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13. Disclosures
ASC Paragraph 805-10-50-2(h)
h. If the acquirer is a public entity, all of the following:
1. The amounts of revenue and earnings of the acquiree since the acquisition
date included in the consolidated income statement for the reporting period.
2. If comparative financial statements are not presented, the revenue and
earnings of the combined entity for the current reporting period as though the
acquisition date for all business combinations that occurred during the year.
3. If comparative financial statements are presented, the revenue and earnings
of the combined entity as though the business combination(s) that occurred
during the current year had occurred as of the beginning of the comparable
prior annual reporting period (supplemental pro forma information). For
example, for a calendar year-end entity, disclosures would be provided for a
business combination that occurs in 20X2, as if it occurred on January 1,
20X1. Such disclosures would not be revised if 20X2 is presented for
comparative purposes with the 20X3 financial statements (even if 20X2 is the
earliest period presented).
4. The nature and amount of any material, nonrecurring pro forma adjustments
directly attributable to the business combination(s) included in the reported
pro forma revenue and earnings (supplemental pro forma information).
If disclosure of any of the information required by [ASC paragraph 805-10-50-
2](h) is impracticable, the acquirer shall disclose that fact and explain why the
disclosure is impracticable. In this context, the term impracticable has the same
meaning as in [ASC] paragraph 250-10-45-9.
IMPRACTICABILITY
13.007 Under ASC paragraphs 250-10-45-9 and 45-10, disclosure of the information
required by ASC paragraph 805-10-50-2(h) would be deemed impracticable only if any
of the following conditions exist:
(a) After making every reasonable effort to do so, the entity is unable to apply the
requirement;
(b) Retrospective application requires assumptions about management’s intent in
a prior period that cannot be independently sustained; or
(c) Retrospective application requires significant estimates of amounts, and it is
impossible to distinguish objectively information about those estimates that:
(1) Provides evidence of circumstances that existed on the date(s) at which
those amounts would be recognized, measured, or disclosed under
retrospective application, and
(2) Would have been available when the financial statements for that prior
period were issued.
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13. Disclosures
ACQUIREE REVENUE AND EARNINGS SINCE ACQUISITION
13.008 The disclosure of revenue and earnings of the acquiree since the acquisition date
is only required by a public entity for the annual reporting period that includes the
acquisition date. (ASC paragraph 805-10-50-2(h)) For example, ABC Corp., a public
entity, acquires DEF Corp. in 20X8, and the acquisition is material to ABC. ABC is
required to disclose revenue and earnings of DEF included in ABC’s consolidated
income statement for the period from the acquisition date to the end of ABC’s 20X8
fiscal year.
SUPPLEMENTAL PRO FORMA INFORMATION
13.009 ASC paragraph 805-10-50-2(h) specifies that when a public entity has a business
combination that occurs during the current reporting period, the entity should disclose
revenue and earnings of the combined entity as though the business combination(s) that
occurred during the current year had occurred as of the beginning of the comparable prior
annual reporting period when comparative information is provided (i.e. supplemental pro
forma information). Comparable disclosures should be made if the acquisition date is
after the reporting date but before the financial statements are issued or are available to
be issued.
13.009a While ASC Topic 805 provides no further guidance as to the form, basis of
presentation of the pro forma disclosures, or types of adjustments to be made to present
the business combination as if it had occurred in the earliest comparative period
presented, in practice, common adjustments to pro forma financial information include
the following.
Adjustment
Acquisition related
costs
Example
Legal fees
Accounting and due diligence fees
Valuation fees
Other incremental consulting and advisory fees
Conforming
accounting policies
Useful life of property, plant, & equipment (PP&E)
ASC Topic 842 elections, such as lessees’ recognition of right-
of-use assets and lease liabilities for short-term leases and
separation of lease and non-lease components
Effects of fair value
adjustments
Inventory cost method
Amortization of acquired intangibles
Depreciation expense associated with fair value adjustment to
acquired PP&E
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13. Disclosures
Adjustment
Example
Financing
Interest expense incurred for new debt raised to fund acquisition
Income taxes
Tax effects, if any, of the transaction
However, under ASC paragraph 805-10-50-2(h) entities should not reflect pro forma
adjustments for indirect effects, such as synergies or dis-synergies.
13.010 The pro forma information required by ASC paragraphs 805-10-50-2(h)(2) to 50-
2(h)(4) is not required to be audited. The auditor would, however, be required to perform
the procedures prescribed by PCAOB AS 2705, Required Supplementary Information.
INTERIM PERIOD PRO FORMA INFORMATION
13.011 ASC paragraph 805-10-50-2(h) requires that pro forma financial information be
provided for the current period and, if comparative financial statements are presented, for
the comparable prior reporting period. This requirement applies to both annual and
interim periods.
Q&A 13.1: Pro Forma Disclosures in Interim Periods
ABC Corp. acquired a significant business in November 20X8. ABC provided the pro
forma disclosures required by ASC paragraph 805-10-50-2(h) in its annual financial
statements for the year ended December 31, 20X8.
Q. Should ABC include pro forma financial information for the acquired business in its
Form 10-Q filing for the quarter ended March 31, 20X9?
A. Yes. While the business combination did not occur in the current period, it is
material to the first quarter results because the comparative interim period (first quarter
of 20X8) did not include the acquired business. Therefore, we believe ABC should
disclose pro forma information for the three months ended March 31, 20X8 in its
March 31, 20X9 financial statements.
ASC paragraph 805-10-50-2 does not specifically discuss the application of the pro
forma disclosures to interim periods. However, the discussion in ASC paragraph 805-
10-50-2 refers to the reporting period and is similar to the discussion previously found
in paragraph 58 of FASB Statement No. 141, which stated that pro forma disclosure in
an interim period is required “if a material business combination is completed during
the current year.”
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13. Disclosures
PRO FORMA INFORMATION REQUIRED TO BE PRESENTED IN FILINGS WITH
THE SEC
13.012 In addition to the disclosures for public entities required under ASC Topic 805,
Article 11 (Article 8 for smaller reporting companies) of Regulation S-X sets forth the
requirements for presentation of pro forma information by SEC registrants that are
required when significant business combinations have occurred. The Article 11 pro forma
information is not presented in the financial statements, and, when required to be
presented, is supplemental to, and more extensive than, the information required by ASC
Topic 805 to be disclosed in the notes to the financial statements. Refer to KPMG
Defining Issues, SEC amends acquisition and disposition disclosures, for additional
discussion of pro forma financial information requirements for SEC registrants under
Article 11.
13.013 – 13.029 Paragraphs not used.
IMMATERIAL BUSINESS COMBINATIONS THAT ARE MATERIAL IN THE
AGGREGATE
13.030 Disclosure for business combinations that are individually immaterial but material
in the aggregate also are required. In particular, disclosure of the information specified in
ASC paragraphs 805-10-50-2(e) through 50-2(h), 805-20-50-1(a) through 50-1(e), and
805-30-50-1(a) through 50-1(f) are required in the aggregate.
BUSINESS COMBINATIONS COMPLETED AFTER REPORTING DATE BUT
BEFORE ISSUANCE OF THE FINANCIAL STATEMENTS
ASC Paragraph 805-10-50-4
If the acquisition date of a business combination is after the reporting date but
before the financial statements are issued or are available to be issued (as
discussed in [ASC] Section 855-10-25), the acquirer shall disclose the
information required by [ASC] paragraph 805-10-50-2 unless the initial
accounting for the business combination is incomplete at the time the financial
statements are issued or are available to be issued. In that situation, the acquirer
shall describe which disclosures could not be made and the reason why they could
not be made.
ASC Paragraph 805-20-50-3
If the acquisition date of a business combination is after the reporting date but
before the financial statements are issued or are available to be issued (as
discussed in [ASC] Section 855-10-25), the acquirer shall disclose the
information required by [ASC] paragraph 805-20-50-1 unless the initial
accounting for the business combination is incomplete at the time the financial
statements are issued or are available to be issued. In that situation, the acquirer
shall describe which disclosures could not be made and the reason why they could
not be made.
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13. Disclosures
ASC Paragraph 805-30-50-3
If the acquisition date of a business combination is after the reporting date but
before the financial statements are issued or are available to be issued (as
discussed in [ASC] Section 855-10-25), the acquirer shall disclose the
information required by [ASC] paragraph 805-30-50-1 unless the initial
accounting for the business combination is incomplete at the time the financial
statements are issued or are available to be issued. In that situation, the acquirer
shall describe which disclosures could not be made and the reason why they could
not be made.
DISCLOSURE OF ADJUSTMENTS RECOGNIZED DURING THE CURRENT PERIOD
ASC Paragraph 805-10-50-5
The acquirer shall disclose information that enables users of its financial
statements to evaluate the financial effects of adjustments recognized in the
current reporting period that relate to business combinations that occurred in the
current or previous reporting periods.
MEASUREMENT PERIOD ADJUSTMENTS
ASC Paragraph 805-20-50-4A
If the initial accounting for a business combination is incomplete (see [ASC]
paragraphs 805-10-25-13 through 25-14) for particular assets, liabilities,
noncontrolling interests, or items of consideration and the amounts recognized in
the financial statements for the business combination thus have been determined
only provisionally, the acquirer shall disclose the following information for each
material business combination or in the aggregate for individually immaterial
business combinations that are material collectively to meet the objective in
[ASC] paragraph 805-10-50-5:
a. The reasons why the initial accounting is incomplete
b. The assets, liabilities, equity interests, or items of consideration for which
the initial accounting is incomplete
c. The nature and amount of any measurement period adjustments recognized
during the reporting period in accordance with [ASC] paragraph 805-10-25-
17, including separately the amount of adjustment to current-period income
statement line items relating to the income effects that would have been
recognized in previous periods if the adjustment to provisional amounts were
recognized as of the acquisition date. Alternatively, an acquirer may present
those amounts separately on the face of the income statement.
13.031 Measurement period adjustments are no longer applied retrospectively in the
acquirer's financial statements. However, we believe that measurement period
adjustments should continue to be reflected in the acquirer's pro forma disclosures on a
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13. Disclosures
retrospective basis. See additional discussion of measurement period disclosures starting
at Paragraph 10.003.
CONTINGENT CONSIDERATION ADJUSTMENTS
ASC Paragraph 805-30-50-4
[ASC] paragraph 805-10-50-5 identifies the second objective of disclosures about
the effects of business combinations that occurred in the current or previous
periods. To meet the objective in that paragraph, the acquirer shall disclose the
following information for each material business combination or in the aggregate
for individually immaterial business combinations that are material collectively:
a. For each reporting period after the acquisition date until the entity collects,
sells, or otherwise loses the right to a contingent consideration asset, or until the
entity settles a contingent consideration liability or the liability is cancelled or
expires, all of the following:
1. Any changes in the recognized amounts, including any differences arising
upon settlement
2. Any changes in the range of outcomes (undiscounted) and the reasons for
those changes
3. The disclosures required by [ASC] Section 820-10-50….
RECONCILIATION OF CHANGES IN GOODWILL DURING THE REPORTING
PERIOD
ASC paragraph 805-30-50-4(b)
b. A reconciliation of the carrying amount of goodwill at the beginning and end of
the reporting period as required by [ASC] paragraph 350-20-50-1. A private
company or not-for-profit entity that adopts the accounting alternative for
amortizing goodwill in Subtopic 350-20 is not required to disclose the
reconciliation.
13.032 ASC paragraph 350-20-50-1 was amended by ASC Topic 805 to significantly
expand the required disclosure of changes in goodwill during the reporting period. Under
the amended guidance, an entity is required to provide a rollforward of goodwill
reflecting:
• The gross amount of goodwill and the accumulated impairment losses at the
beginning of the period
• Additional goodwill recognized during the period, except goodwill included in
a disposal group that, on acquisition, meets the criteria to be classified as held
for sale
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13. Disclosures
• Goodwill included in a disposal group classified as held for sale and goodwill
derecognized during the period without having previously been reported in a
disposal group classified as held for sale
• Adjustments resulting from the recognition of deferred tax assets during the
period
•
Impairment losses recognized during the period
• Net exchange differences arising during the period
• Any other changes in the carrying amounts during the period
• The gross amount of goodwill and accumulated impairment losses at the end
of the period.
ASC paragraph 350-20-55-24 provides an example disclosure of the rollforward of
goodwill.
13.033 The above disclosures are required for business combinations accounted for under
ASC Topic 805. Disclosures about adjustments related to business combinations in which
the acquisition date preceded the effective date of ASC Topic 805 are subject to the
disclosure requirements under Statement 141.
ADDITIONAL DISCLOSURES TO MEET DISCLOSURE
OBJECTIVES
ASC Paragraph 805-10-50-7
If the specific disclosures required by [ASC] Subtopic [805-10] and other
generally accepted accounting principles (GAAP) do not meet the objectives set
out in [ASC] paragraphs 805-10-50-1 and 805-10-50-5, the acquirer shall disclose
whatever additional information is necessary to meet those objectives.
13.034 The FASB concluded that it is not necessary or possible to identify all of the
specific information that may be necessary to meet the disclosure objectives for all
business combinations. Instead, the FASB decided to include the overall disclosure
objectives stated in ASC paragraphs 805-10-50-1 and 50-5, and to specify particular
disclosures that are generally required to meet the overall objectives. However, if the
specific disclosures required by ASC Topic 805 and the disclosures required by other
GAAP do not satisfy the overall disclosure objectives, the acquirer is required to disclose
the additional information necessary to do so.
EXAMPLE DISCLOSURES
13.035 The following illustrative disclosures are taken from ASC paragraphs 805-10-55-
37 through 55-49.
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13. Disclosures
Example 13.1: Disclosure of a Material Business Combination in the Year of
Acquisition, Completed During the Reporting Period
Note X: Acquisitions
Paragraph Reference
ASC paragraphs 805-10-
50-2(a) through 50-2(d)
ASC paragraphs 805-30-
50-1(a) and 50-1(e)
On June 30, 20X0, AC acquired 15 percent of the
outstanding common shares of TC. On June 30, 20X2, AC
acquired 60 percent of the outstanding common shares of
TC. TC is a provider of data networking products and
services in Canada and Mexico. As a result of the
acquisition, AC is expected to be the leading provider of
data networking products and services in those markets. It
also expects to reduce costs through economies of scale.
The goodwill of $2,500 arising from the acquisition consists
largely of the synergies and economies of scale expected
from combining the operations of AC and TC. All of the
goodwill was assigned to AC’s network segment.
ASC paragraph 805-30-
50-1(d)
None of the goodwill recognized is expected to be
deductible for income tax purposes.
The following table summarizes the consideration paid for
TC and the amounts of the assets acquired and liabilities
assumed recognized at the acquisition date, as well as the
fair value at the acquisition date of the noncontrolling
interest in TC.
ASC paragraph 805-30-
50-1(b)
ASC paragraph 805-30-
50-1(b)(1)
ASC paragraph 805-30-
50-1(b)(4)
ASC paragraph 805-30-
50-1(b)(3),
ASC paragraph 805-30-
50-1(c)
ASC paragraph 805-10-
50-2(g)(1)
At June 30, 20X2
Consideration
Cash
Equity instruments (100,000 common shares
of AC)
Contingent consideration arrangement
Fair value of total consideration
transferred
Fair value of AC’s equity interest in TC
held before the business combination
$
5,000
4,000
1,000
10,000
2,000
12,000
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13. Disclosures
ASC paragraphs 805-10-
50-2(e) and 50-2(f)
Acquisition-related costs (included in
selling, general, and administrative expenses
in AC’s income statement for the year ending
December 31, 20X2)
ASC paragraph 805-20-
50-1(c)
Recognized amounts of identifiable assets
acquired and liabilities assumed
Financial assets
Inventory
Property, plant, and equipment
Identifiable intangible assets
Financial liabilities
Liability arising from a contingency
Total identifiable net assets
ASC paragraph 805-20-
50-1(e)(1)
Noncontrolling interest in TC
Goodwill
1,250
3,500
1,000
10,000
3,300
(4,000)
(1,000)
12,800
(3,300)
2,500
12,000
ASC paragraph 805-30-
50-1(b)(4)
The fair value of the 100,000 common shares issued as part
of the consideration paid for TC ($4,000) was determined
on the basis of the closing market price of AC’s common
shares on the acquisition date.
ASC paragraphs 805-30-
50-1(b)(3), 50-1(c), and
ASC paragraph 805-10-
50-4(a)
The contingent consideration arrangement requires AC to
pay the former owners of TC 5 percent of the revenues of
XC, an unconsolidated equity investment owned by TC, in
excess of $7,500 for 20X3, up to a maximum amount of
$2,500 (undiscounted). The potential undiscounted amount
of all future payments that AC could be required to make
under the contingent consideration arrangement is between
$0 and $2,500. The fair value of the contingent
consideration arrangement of $1,000 was estimated by
applying the income approach. That measure is based on
significant inputs that are not observable in the market,
which ASC Section 820-10-35 refers to as Level 3 inputs.
Key assumptions include (a) a discount rate range of 20
percent to 25 percent and (b) a probability adjusted level of
revenues in XC between $10,000 and $20,000. As of
December 31, 20X2, the amount recognized for the
contingent consideration arrangement, the range of
outcomes, and the assumptions used to develop the
estimates had not changed.
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13. Disclosures
ASC paragraph 805-20-
50-1(b)
The fair value of the financial assets acquired includes
receivables under capital leases of data networking
equipment with a fair value of $2,000. The gross amount
due under the contracts is $3,100, of which $450 is expected
to be uncollectible.
ASC paragraph 805-20-
50-4A
The fair value of the acquired identifiable intangible assets
of $3,300 is provisional pending receipt of the final
valuations for those assets.
ASC paragraphs 805-20-
50-1(d) and 50-5
ASC paragraph 805-20-
50-1(e)
ASC paragraph 805-10-
50-2(g)(2)
A liability of $1,000 has been recognized for expected
warranty claims on products sold by TC during the last 3
years. AC expects that the majority of this expenditure will
be incurred in 20X3 and that all will be incurred by the end
of 20X4. The potential undiscounted amount of all future
payments that AC could be required to make under the
warranty arrangements is estimated to be between $500 and
$1,500. As of December 31, 20X2, there has been no
change since June 30, 20X2, in the amount recognized for
the liability or any change in the range of outcomes or
assumptions used to develop the estimates.
The fair value of the noncontrolling interest in TC, a private
company, was estimated by applying the income approach
and a market approach. This fair value measurement is
based on significant inputs that are not observable in the
market and thus represents a Level 3 measurement as
defined in ASC Section 820-10-35. Key assumptions
include (a) a discount rate range of 20 percent to 25 percent,
(b) a terminal value based on a range of terminal EBITDA
multiples between 3 and 5 (or, if appropriate, based on long-
term sustainable growth rates ranging between 3 percent and
6 percent), (c) financial multiples of companies deemed to
be similar to TC, and (d) adjustments because of the lack of
control or lack of marketability that market participants
would consider when estimating the fair value of the
noncontrolling interest in TC.
AC recognized a gain of $500 as a result of remeasuring to
fair value its 15 percent equity interest in TC held before the
business combination. The gain is included in other income
in AC’s income statement for the year ending December 31,
20X2.
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385
13. Disclosures
ASC paragraph 805-10-
50-2(h)
The amounts of TC’s revenue and earnings included in
AC’s consolidated income statement for the year ended
December 31, 20X2, and the revenue and earnings of the
combined entity had the acquisition date been January 1,
20X2 (if comparative financial statements are not
presented), or January 1, 20X1 (if comparative financial
statements are presented), are:
ASC paragraph 805-10-
50-2(h)(1)
ASC paragraph 805-10-
50-2(h)(2)
ASC paragraph 805-10-
50-2(h)(3)
Actual from 6/30/20X2–
12/31/20X2
Supplemental pro forma
from 1/1/20X2–
12/31/20X2
Supplemental pro forma
for 1/1/20X1–
12/31/20X1
Revenue
Earnings
$4,090
$1,710
$27,670
$12,870
$26,985
$12,325
13.036 The disclosure example provided in ASC Topic 805 (shown above) does not
include replacement awards or deferred taxes, both of which may be common elements of
business combinations and would be included in the required disclosures. Therefore, this
example should be seen as illustrative but does not address all possible items for which
disclosure would be required.
1 ASU 2016-13, Credit Losses, is effective for public business entities that are SEC filers, excluding entities
eligible to be smaller reporting companies as defined by the SEC, for annual and interim periods in fiscal
years beginning after December 15, 2019. The one-time determination of whether an entity is eligible to be
a smaller reporting company shall be based on an entity’s most recent determination as of November 15,
2019, in accordance with SEC regulations.
For all other entities, it is effective for annual and interim periods in fiscal years beginning after December
15, 2022. Early adoption is permitted for annual and interim periods in fiscal years beginning after
December 15, 2018.
2 ASU 2016-02, Leases, changes certain aspects of accounting for leases acquired in a business
combination. The ASU is effective for public business entities, certain not-for-profit entities, and certain
employee benefit plans for annual and interim periods in fiscal years beginning after December 15, 2018.
For not-for-profit entities that have issued or are conduit bond obligors for securities that are traded, listed,
or quoted on an exchange or an over-the-counter market that have not yet issued financial statements or
made financial statements available for issuance as of June 3, 2020, it is effective for annual and interim
periods in fiscal years beginning after December 15, 2019. For all other entities, the ASU is effective for
annual periods in fiscal years beginning after December 15, 2021, and interim periods in fiscal years
beginning after December 15, 2022. Early adoption is permitted. See discussion in KPMG Handbook,
Leases.
3 ASU 2016-02, Leases, changes certain aspects of accounting for leases acquired in a business
combination. The ASU is effective for public business entities, certain not-for-profit entities, and certain
employee benefit plans for annual and interim periods in fiscal years beginning after December 15, 2018.
For not-for-profit entities that have issued or are conduit bond obligors for securities that are traded, listed,
or quoted on an exchange or an over-the-counter market that have not yet issued financial statements or
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386
13. Disclosures
made financial statements available for issuance as of June 3, 2020, it is effective for annual and interim
periods in fiscal years beginning after December 15, 2019. For all other entities, the ASU is effective for
annual periods in fiscal years beginning after December 15, 2021, and interim periods in fiscal years
beginning after December 15, 2022. Early adoption is permitted. See discussion in KPMG Handbook,
Leases.
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Section 14 - Effective Date and Transition
Detailed Contents
Effective Date
Transition
Acquisitions Prior to the Effective Date of ASC Topic 805
Income Taxes
Acquisition-Related Costs Incurred in a Business Combination which Commenced
Prior to, but Was Completed after, the Effective Date of ASC Topic 805
Transition for Contingent Consideration from Acquisitions Prior to the Effective Date
of ASC Subtopic 958-805
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Effective Date and Transition
EFFECTIVE DATE
Statement 141(R)
74. [ASC Topic 805] shall be applied prospectively to business combinations for
which the acquisition date is on or after the beginning of the first annual reporting
period beginning after December 15, 2008. Early adoption is prohibited.
14.000 The effective date for ASC Topic 805, Business Combinations, means that, for
calendar-year companies, the Topic was effective for 2009. The FASB concluded that
this date would allow sufficient time for issuers to prepare for implementation of this
Topic.
TRANSITION
ACQUISITIONS PRIOR TO THE EFFECTIVE DATE OF ASC TOPIC 805
Statement 141(R)
75. Assets and liabilities that arose from business combinations whose acquisition
dates preceded the effective date of ASC Topic 805 shall not be adjusted upon
application of this Topic.
14.001 The FASB concluded it would not be feasible to apply ASC Topic 805
retrospectively and, accordingly, specified its application only to acquisitions occurring
on or after its effective date. The accounting for the assets and liabilities that arose from
business combinations occurring prior to the effective date of ASC Topic 805 is not
changed by issuance of ASC Topic 805, with the sole exception of changes after its
effective date in the valuation allowance for acquired deferred tax assets and changes in
acquired income tax uncertainties that arose from business combinations occurring prior
to the Statement’s effective date.
14.002 When an entity has acquired other entities (acquirees) both before and after the
effective date of ASC Topic 805, there will sometimes be significant differences in the
accounting for similar transactions or events related to those acquisitions that occur in
subsequent periods. For example, significant differences could result in the accounting
for changes in the measurement and the subsequent settlement of contingent
consideration arrangements (see Contingent Consideration in Sections 6 and 12) and
liabilities related to exit activities of the acquiree (see Liabilities Associated with
Restructuring or Exit Activities of the Acquiree in Section 7). Some of these differences
may not be eliminated for a prolonged period following the effective date of ASC Topic
805; for example, a contingent consideration arrangement entered into in connection with
a business combination prior to the effective date of ASC Topic 805 will continue to be
accounted for under FASB Statement No. 141, Business Combinations, and it could be
several years after the effective date of ASC Topic 805 before the amount of payments
required to settle the contingent consideration arrangement are finally determined and
recognized by the acquirer.
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Effective Date and Transition
INCOME TAXES
Statement 141(R)
77. For business combinations in which the acquisition date was before the
effective date of [ASC Topic], the acquirer shall apply the requirements of [ASC
Topic 740], as amended by [ASC Topic 805], prospectively. That is, the acquirer
shall not adjust the accounting for prior business combinations for previously
recognized changes in acquired tax uncertainties or previously recognized
changes in the valuation allowance for acquired deferred tax assets. However,
after the effective date of [ASC Topic 805]:
a. The acquirer shall recognize, as an adjustment to income tax expense (or a
direct adjustment to contributed capital in accordance with [ASC paragraph
740-10-45-20], changes in the valuation allowance for acquired deferred tax
assets.
b. The acquirer shall recognize changes in the acquired income tax positions
in accordance with [ASC Topic 740], as amended by [ASC Topic 805].
14.003 Thus, for acquired tax uncertainties and valuation allowances for acquired
deferred tax assets arising from business combinations preceding the effective date of
ASC Topic 805, the acquirer:
• Does not adjust the accounting for previously recognized changes in acquired
tax uncertainties or the valuation allowance for deferred tax assets that were
recognized prior to the effective date of ASC Topic 805;
• Recognizes changes in the valuation allowance for acquired deferred tax
assets after the effective date of ASC Topic 805 as adjustments to income tax
expense (or as a direct adjustment to contributed capital) in the same manner
as those changes are recognized for business combinations that occur after the
effective date of ASC Topic 805; and
• Recognizes changes in acquired tax uncertainties after the effective date of
ASC Topic 805 as adjustments to income tax expense in the same manner as
those changes are recognized for business combinations that occur after the
effective date of ASC Topic 805.
See KPMG Handbook, Accounting for Income Taxes, Section 10 for a discussion of
income tax considerations in a business combination.
ACQUISITION-RELATED COSTS INCURRED IN A BUSINESS COMBINATION
WHICH COMMENCED PRIOR TO, BUT WAS COMPLETED AFTER, THE EFFECTIVE
DATE OF ASC TOPIC 805
14.004 An entity may initiate a business combination before the effective date of ASC
Topic 805 and incur acquisition-related costs. Because ASC Topic 805 prohibits early
adoption, the entity would capitalize the acquisition-related costs for this type of business
combination as required under Statement 141. However, ASC Topic 805 requires that an
entity charge acquisition-related costs to expense as incurred. Thus, if an acquisition
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390
Effective Date and Transition
commences before the effective date of ASC Topic 805, but completion is not expected
until after ASC Topic 805’s effective date, a question arises as to how the acquisition
costs incurred and capitalized before the effective date of ASC Topic 805 should be
accounted for.
14.005 Based on discussions with the FASB and SEC staffs, we believe that any of the
following three alternatives are acceptable methods to account for acquisition-related
costs capitalized by an acquirer before the effective date of Statement 141(R) (ASC
Topic 805):
(1) Expense the costs when it becomes probable (or virtually certain) that the
acquisition will not be completed until after the effective date of ASC Topic
805. Thus, once it has become probable that the acquirer will not complete the
acquisition before the effective date of ASC Topic 805, any acquisition-
related costs previously capitalized would be recognized as expense, and any
costs incurred thereafter would be charged to expense as incurred.
(2) Expense the costs on the effective date of ASC Topic 805.
(3) Expense the costs retrospectively (in the period incurred), using the guidance
for a change in accounting principles in ASC Topic 250, Accounting Changes
and Error Corrections, on the effective date of ASC Topic 805. This method
requires retrospective application of the accounting principle to prior period
financial statements.
14.006 The method selected by an acquirer to account for such costs is an accounting
policy election and, therefore, should be disclosed in accordance with ASC paragraphs
235-10-50-1 through 50-6, and applied consistently to those costs. See the discussion of
the accounting for the income tax effects of acquisition-related costs in KPMG
Handbook, Accounting for Income Taxes, Section 10 under Business Combinations –
Specific Application Matters.
TRANSITION FOR CONTINGENT CONSIDERATION FROM ACQUISITIONS PRIOR
TO THE EFFECTIVE DATE OF ASC SUBTOPIC 958-805
14.007 For business combinations occurring in annual reporting periods beginning after
December 15, 2009, the requirements of ASC Topic 805 generally applied to business
combinations involving not-for-profit entities (see Paragraph 1.017). Similar to the
guidance in Paragraph 14.003 for business combinations involving for-profit entities, not-
for-profit entities that consummated business combinations prior to the effective date of
ASC Subtopic 958-805 (originally Statement No. 164) should continue to account for
contingent consideration in those transactions in accordance with APB Opinion No. 16.
Any additional consideration that becomes payable under those contingent consideration
provisions will result in an adjustment to goodwill from that transaction.
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Section 15 – Noncontrolling Interests in
Consolidated Financial Statements
See KPMG Handbook, Consolidation, for details on the subsequent accounting for
noncontrolling interests.
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392
Section 16 - Overview of ASC Subtopic
820-10
Detailed Contents
Fair Value Measurements
Objectives of ASC Subtopic 820-10
Application of ASC Subtopic 820-10 to Business Combination Fair Value
Measurements
Measurement
Definition of Fair Value
The Asset or Liability
The Price
The Transaction
The Principal Market
Example 16.1: Determining the Principal Market
The Most Advantageous Market
Example 16.2: Determining the Exit Market
Market Participants
Market Participants – Strategic and Financial Buyers
Example 16.3: Strategic and Financial Buyers (Highest and Best Use)
Application to Nonfinancial Assets - Highest and Best Use
Example 16.4: Highest and Best Use Valuation Premise
Example 16.5: In Combination with Other Assets Valuation Premise
Example 16.6: Stand-Alone Valuation Premise
Example 16.6a: Impact of Management's Intention on a Valuation
Application to Liabilities and Instruments Classified in a Reporting Entity’s
Shareholders’ Equity
Example 16.7: Effect of Nonperformance Risk on the Fair Value of a Liability
Example 16.8: Non-Actively Traded Debt Instrument
Fair Value at Initial Recognition
Valuation Approaches
Market Approach
Income Approach
Cost Approach
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Example 16.9: Income vs. Cost Approaches – Software Asset
16. Overview of ASC Subtopic 820-10
Valuation Analysis Inputs
Fair Value Hierarchy
Level 1 Inputs
Level 2 Inputs
Level 3 Inputs
Inputs Based on Bid and Ask Prices
Determining Fair Value When the Volume and Level of Activity for the Asset or
Liability Have Significantly Decreased and Identifying Transactions That Are not
Orderly
Determining Fair Value When the Volume and Level of Activity for the Asset or
Liability Have Significantly Decreased
Identifying Transactions That Are Not Orderly
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16. Overview of ASC Subtopic 820-10
FAIR VALUE MEASUREMENTS
ASC Paragraph 805-20-30-1
The acquirer shall measure the identifiable assets acquired, the liabilities assumed,
and any noncontrolling interest in the acquiree at their acquisition-date fair values.
16.000 ASC Topic 805, Business Combinations, requires that the acquirer in a business
combination measure the identifiable assets acquired, the liabilities assumed, and any
acquired noncontrolling interest in the acquiree at their acquisition-date fair values (with
certain exceptions—see Section 7, Recognizing and Measuring the Identifiable Assets
Acquired, the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree).
Assets acquired, liabilities assumed, and consideration transferred that are subject to the
measurement exceptions are measured in accordance with the guidance specified for
those exceptions, rather than at fair value. ASC Topic 805 also requires that the
consideration transferred including any contingent consideration be measured at fair
value (see Section 6, Recognizing and Measuring the Consideration Transferred). This
Section provides a general overview for determining fair value for financial reporting
purposes and common valuation approaches used to estimate fair value in accordance
with ASC Subtopic 820-10, Fair Value Measurement – Overall. Fair value measurements
require significant judgment and, for some items, the use of complex valuation
techniques and methods to determine fair value. The use of valuation professionals to
assist in the process is fairly common.
OBJECTIVES OF ASC SUBTOPIC 820-10
16.001 ASC Subtopic 820-10 defines fair value for financial reporting purposes,
establishes a framework for measuring fair value, and requires disclosures about fair
value measurements. ASC Subtopic 820-10 was developed to provide increased
consistency and comparability of fair value measurements required under U.S. GAAP, as
well as to require more transparent disclosures about fair value measurements including
the levels within the fair value hierarchy for those measurements. ASC paragraph 820-
10-05-1A
16.002 ASC Subtopic 820-10 emphasizes that fair value is a market participant-based
exit price measurement, and not an entity-specific measurement. ASC Subtopic 820-10
establishes a fair value hierarchy that distinguishes between (1) market participant
assumptions developed based on market data obtained from sources independent of the
reporting entity (observable inputs) and (2) the reporting entity’s own assumptions about
market participant assumptions developed based on the best information available in the
circumstances (unobservable inputs). ASC Subtopic 820-10 emphasizes that valuation
techniques used to measure fair value should maximize the use of observable inputs.
16.003 Generally, the framework for measuring fair value includes determining:
(a) The particular asset or liability that is the subject of the measurement
(consistent with its unit of account);
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16. Overview of ASC Subtopic 820-10
(b) For a nonfinancial asset, the valuation premise that is appropriate for the
measurement (consistent with its highest and best use);
(c) The principal (or most advantageous) market for the asset or liability;
(d) The valuation approaches and underlying technique(s) appropriate for the
measurement, considering the availability of data with which to develop
inputs that represent the assumptions that market participants would use when
pricing the asset or liability and the level of the fair value hierarchy within
which the inputs are categorized. ASC paragraph 820-10-55-1
16.004 While ASC Subtopic 820-10 does not specifically address the measurement of
noncontrolling interests, the same framework applies. While the following discussion
refers to assets or liabilities, the guidance also applies to the fair value measurement of
any noncontrolling interests.
16.005 Once the appropriate valuation approaches and underlying technique(s) have been
determined for the asset or liability, the inputs used in the fair value measurement are
categorized into three hierarchical levels - quoted market prices in active markets for
identical assets or liabilities (Level 1), other observable market inputs (Level 2), and
unobservable inputs (Level 3). These concepts will be discussed in detail in the following
subsections.
APPLICATION OF ASC SUBTOPIC 820-10 TO BUSINESS COMBINATION FAIR
VALUE MEASUREMENTS
16.006 ASC Subtopic 820-10 applies to all fair value measurements required by ASC
Topic 805. As noted above, ASC Topic 805 generally requires that identifiable assets
acquired, liabilities assumed, and noncontrolling interest be measured at acquisition-date
fair value. ASC Topic 805 does, however, provide for certain exceptions whereby certain
items are measured at an amount other than fair value (see Section 7).
16.007 ASC Subtopic 820-10 does not eliminate the practicability exceptions to fair
value measurements that are provided by other ASC Topics. ASC Subtopic 820-10
describes the practicability exceptions, as follows:
(a) The use of a transaction price (an entry price) to measure fair value (an exit
price) at initial recognition of guarantees in accordance with ASC Topic 460.
(b) An exemption to the requirement to measure fair value if fair value is not
reasonably determinable such as the following:
(1) Nonmonetary assets in accordance with ASC Topic 845 and ASC Sections
605-20-25 and 605-20-50.
(2) Asset retirement obligations in accordance with ASC Subtopic 410-20 and
ASC Sections 440-10-50 and 440-10-55.
(3) Restructuring obligations in accordance with ASC Topic 420.
(4) Participation rights in accordance with ASC Subtopics 715-30 and 715-60.
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16. Overview of ASC Subtopic 820-10
(c) An exemption to the requirement to measure fair value if fair value cannot be
measured with sufficient reliability (such as contributions in accordance with
ASC Topic 958 and ASC Subtopic 720-25.
(d) The use of particular measurement methods referred to in ASC paragraph
805-20-30-10 that allow measurements other than fair value for specified
assets acquired and liabilities assumed in a business combination. ASC
paragraph 820-10-15-3.
16.008 Paragraph not used.
16.009 In addition to including the various practicability exceptions that existed in other
topics, ASC Topic 820 provides practical expedients in applying the fair value
framework in certain instances. For example, ASC paragraphs 820-10-35-59 through 35-
62 provide a practical expedient for investors that have investments in certain investment
vehicles, such as hedge funds, private equity funds, venture capital funds, funds of funds,
and in foreign or other vehicles (e.g., real estate funds) that calculate and report net asset
value (NAV) or an equivalent amount to use that amount as fair value if certain
conditions are met. Investors may use NAV to estimate the fair value of investments in
investment companies that do not have a readily determinable fair value if the investees
have the attributes of investment companies and NAV, or its equivalent, is calculated
consistent with the guidance in ASC Topic 946, Financial Services—Investment
Companies, which generally requires investments to be measured at fair value (see
Section Q in KPMG Fair Value Measurements). The practical expedient should be
applied on an investment-by-investment basis and applied consistently to the investor’s
entire position in a particular investment unless it is probable as of the reporting date that
all or a portion of the investment will be sold at an amount other than NAV (e.g., in a
secondary market transaction). In those instances, the investor would instead be required
to estimate the fair value of the investment considering all of the rights and obligations
inherent in the investment and other market data applicable to the investment interest (see
KPMG Fair Value Measurements Q&A G70).
16.009a In addition, ASC Topic 820 allows for mid-market pricing or other pricing
conventions as a practical expedient when measuring fair value within the bid-ask spread.
See Paragraphs 16.068 through 16.070 and KPMG Fair Value Measurements Q&A I40
for further details on Inputs Based on Bid and Ask Prices.
MEASUREMENT
DEFINITION OF FAIR VALUE
ASC Paragraph 820-10-35-2
[ASC Subtopic 820-10] defines fair value as the price that would be received to
sell an asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date.
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16. Overview of ASC Subtopic 820-10
16.010 The objective of a fair value measurement under ASC Subtopic 820-10 is to
estimate the price that would be received to sell an asset currently or paid to transfer a
liability in an orderly transaction between market participants in the principal (or most
advantageous) market for that asset or liability at the measurement date. That is, fair
value measurements are based on an exit price notion considered from the perspective of
a market participant that is prepared to buy an asset from an entity or willing to accept an
entity’s performance obligation. The fair value of an asset or liability is based on a
hypothetical transaction at the measurement date considered from the perspective of a
market participant that holds the asset or owes the liability. The exit price notion is
consistent with the FASB’s objective for fair value measurements and is consistent with
FASB Concepts Statement No. 6, Elements of Financial Statements, for the definition of
an asset and liability, because an exit price is developed based on current expectations
about future inflows associated with the asset and the future outflows associated with the
liability from the perspective of market participants. Statement 157, par. C26
THE ASSET OR LIABILITY
ASC Paragraph 820-10-35-2B
A fair value measurement is for a particular asset or liability. Therefore, when
measuring fair value a reporting entity shall take into account the characteristics
of the asset or liability if market participants would take those characteristics into
account when pricing the asset or liability at the measurement date. Such
characteristics include, for example, the following:
a. The condition and location of the asset
b. Restrictions, if any, on the sale or use of the asset.
16.011 A fair value measurement is for a particular asset or liability, considering various
factors such as its condition and location at the measurement date. The asset or liability
may be a stand-alone asset or liability such as a financial instrument or a group of assets
or liabilities such as a reporting unit. When measuring the fair value of an asset or
liability, an entity first determines the item being measured, giving consideration to its
unit of account.
16.012 Often, an asset or liability is easily identifiable as an individual asset or liability.
For example, the unit of account for a portfolio of identical financial instruments that is
actively traded is the individual security within the portfolio. For a group of operating
assets in a manufacturing plant that are acquired in a business combination, the unit of
account generally is at the level at which the asset is separable or substitutable with other
equivalent assets (e.g., a piece of equipment within the manufacturing plant).
16.013 In some circumstances, applicable U.S. GAAP specifies or permits that the unit of
account may be at an aggregated level rather than at the individual asset or liability level.
For example, ASC Topic 805 permits the aggregation of an operating license and a
nuclear power plant into a single asset if the useful lives of those assets are similar. (ASC
paragraph 805-20-55-2(b)) To determine the appropriate unit of account for measuring
fair value, an entity first identifies whether specific accounting standards require or
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16. Overview of ASC Subtopic 820-10
permit the unit of account to be at a level of aggregation above the individual asset or
liability level, such as an asset group, a reporting unit, or a business.
THE PRICE
ASC Subtopic 820-10-35-9A
Fair value is the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction in the principal (or most advantageous) market
at the measurement date under current market conditions (that is, an exit price)
regardless of whether that price is directly observable or estimated using another
valuation technique.
16.014 A fair value measurement assumes that the asset or liability being exchanged is
done so in an orderly transaction between market participants. The concept of an orderly
transaction assumes access to the relevant market for a period prior to the measurement
date to allow for marketing activities that are usual and customary for transactions
involving the specific assets or liabilities being measured at fair value. The concept of an
orderly transaction distinguishes fair value from forced liquidation value, which reflects
the price that would be received or paid in a distressed sale, where a limited marketing
period is available for the sale of the assets or liabilities.
16.015 For assets or liabilities that are actively traded in only one market, the exit price is
readily available because market participants have engaged in transactions to buy and sell
the identical asset or liability. For assets or liabilities that are actively traded in more than
one market, it is necessary to identify the appropriate reference market. For assets or
liabilities for which there is no active trading of the identical asset or liability,
determining the appropriate exit price requires the utilization of valuation techniques or
adjustments to the observed prices using assumptions that market participants would
consider when transacting for similar assets or liabilities.
THE TRANSACTION
ASC Paragraph 820-10-35-5
A fair value measurement assumes that the transaction to sell the asset or transfer
the liability takes place either:
a. In the principal market for the asset or liability
b. In the absence of a principal market, in the most advantageous market for
the asset or liability.
THE PRINCIPAL MARKET
16.016 According to ASC Subtopic 820-10, the principal market is the market with the
greatest volume and level of activity for the asset or liability. When more than one market
exists for an asset or liability, the source of the exit price used in a fair value
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measurement depends on whether a principal market exists for the entity with respect to
that asset or liability.
16.017 When an entity engages in transactions to buy or sell an asset or transfer a liability
in multiple marketplaces, the entity first considers whether there is a specific marketplace
where a majority of transactions (i.e., greatest volume of transactions) for the asset or
liability occur. The perspective of the reporting entity is not the primary influence in the
market determination.
16.018 The principal market determination takes into account where the asset sale or
liability transfer takes place with the most volume. In this way the valuation subject
drives the identification of the market. However, the reporting entity will need to have
access to the principal market. Thus, the fair value of comparable valuation subjects may
differ among entities.
Example 16.1: Determining the Principal Market
ABC Corp.’s common shares trade on both the New York and London Stock Exchanges,
with the volume on New York Stock Exchange representing 80% of the total volume for
ABC’s common shares. DEF Corp., a holder of ABC common shares, principally buys
and sells ABC common shares on the London Stock Exchange. What is the principal
market for DEF – the New York or London Stock Exchange?
If DEF has access to the New York Stock Exchange, it is the principal market because
the majority of ABC’s common shares are traded there. If DEF cannot access the New
York Stock Exchange, the principal market for DEF is the London Stock Exchange.
16.019 ASC Subtopic 820-10 does not provide detailed guidance for determining a
principal market. Specifically, ASC Subtopic 820-10 does not discuss the assessment
period for determining the greatest volume and level of activity for the asset or liability to
identify the principal market. However, the definition of principal market under ASC
Subtopic 820-10 suggests that it may be appropriate for an entity to consider both: (1) the
historical volume and level of activity in each of the markets in which the securities are
sold and (2) the anticipated volume and level of activity in markets in which securities
are sold to the extent the future activity is expected to differ from historical levels. The
analysis should be performed for each class of securities (e.g., share investments, debt
obligations, investments in loans) traded in multiple marketplaces to assess the volume
and level of activity in each market. When contrary evidence does not exist, the market in
which the reporting entity normally transacts is presumed to be the principal or most
advantageous market. Because an entity’s trading activities can change over time, a
reassessment of its principal market (or lack thereof) should be performed at regular
intervals or based on changes in facts or circumstances when events occur that may
change the entity’s assessment of its principal market. The reporting entity is not required
to perform an exhaustive search of all possible markets but it would consider reasonably
available information.
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16.020 There may be circumstances when no single market represents the principal
market for a particular asset or liability that is measured at fair value. When there is no
principal market for the asset or liability, then fair value is determined based on the price
in the most advantageous market for the asset or liability.
16.020a See Section E in KPMG Fair Value Measurements for more discussion and
Q&As on principle market.
THE MOST ADVANTAGEOUS MARKET
16.021 According to ASC Subtopic 820-10, the most advantageous market is defined as
the market that maximizes the amount that would be received to sell the asset or
minimizes the amount that would be paid to transfer the liability, after taking into account
transaction costs and transportation costs. Determining the most advantageous market
requires that an entity review multiple markets in which it sells assets or transfers
liabilities to identify the most advantageous market. This assessment should be performed
in each reporting period when a principal market does not exist for the asset or liability.
16.022 As with a principal market, the most advantageous market should be considered
first taking into account where the asset sale or liability transfer takes place. Also, the
reporting entity’s access to the most advantageous market is evaluated. This can result in
different fair values among comparable valuation subjects from entity to entity.
16.023 There may be differences between exit prices indicated by the principal market
and the most advantageous market. If a principal market is identified, the price from the
principal market should be used in the fair value measurement even if the price from the
most advantageous market is higher.
Example 16.2: Determining the Exit Market
An asset is sold in two different active markets at different prices. A reporting entity
enters into transactions in both markets and can access the price in both markets at the
measurement date. In Market A, the price that would be received is $26, transaction costs
in that market are $3, and the costs to transport the asset to that market are $2 (i.e., the net
amount that would be received is $21). In Market B, the price that would be received is
$25, transaction costs in that market are $1, and the costs to transport the asset to that
market are $2 (i.e., the net amount that would be received in Market B is $22).
(a) If Market A is the principal market for the asset (i.e., the market with the
greatest volume and level of activity for the asset), the fair value of the asset
would be measured using the price that would be received in that market, after
taking into account transportation costs ($24 per share).
(b) If Market B is the principal market for the asset (i.e., the market with the
greatest volume and level of activity for the asset), the fair value of the asset
would be measured using the price that would be received in that market, after
taking into account transportation costs ($23 per share).
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(c) If neither market is the principal market for the asset, the fair value of the
asset would be measured using the price in the most advantageous market.
The most advantageous market is the market that maximizes the amount that
would be received to sell the asset after taking into account transaction costs
and transportation costs (i.e., the net amount that would be received in the
respective markets). Because the reporting entity would maximize the net
amount that would be received for the asset in Market B ($22), the fair value
of the asset would be measured using the price in that market ($25), less
transportation costs ($2), resulting in a fair value measurement of $23.
Although transaction costs are taken into account when determining which
market is the most advantageous market, the price used to measure the fair
value of the asset is not adjusted for transaction costs (although it is adjusted
for transportation costs).
ASC paragraphs 820-10-55-43 through 45A
MARKET PARTICIPANTS
ASC Master Glossary: Market Participants
Buyers and sellers in the principal (or most advantageous) market for the asset or
liability that have all of the following characteristics:
a. They are independent of each other, that is, they are not related parties,
although the price of a related party transaction may be used as an input to a
fair value measurement if the reporting entity has evidence that the transaction
was entered into at market terms
b. They are knowledgeable, having a reasonable understanding about the asset
or liability and the transaction using all available information, including
information that might be obtained through due diligence efforts that are usual
and customary
c. They are able to enter into a transaction for the asset or liability
d. They are willing to enter into a transaction for the asset or liability, that is,
they are motivated but not forced or otherwise compelled to do so.
ASC Paragraph 820-10-35-9
A reporting entity shall measure the fair value of an asset or a liability using the
assumptions that market participants would use in pricing the asset or liability,
assuming that market participants act in their economic best interest. In
developing those assumptions, the reporting entity need not identify specific
market participants. Rather, the reporting entity shall identify characteristics that
distinguish market participants generally, considering factors specific to all of the
following:
a. The asset or liability
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b. The principal (or most advantageous) market for the asset or liability
c. Market participants with whom the reporting entity would enter into a
transaction in that market.
16.024 Market participants are buyers and sellers in the principal (or most advantageous)
market for an asset or liability. ASC Subtopic 820-10 emphasizes that fair value is a
market participant-based measurement, not an entity-specific measurement, and that fair
value measurements should be determined based on assumptions that market participants
would use in pricing the asset or liability. ASC paragraph 820-10-35-9
16.025 When evaluating the assumptions that a market participant uses when pricing an
asset or liability, an entity would first use observable market information, if such
information exists. If observable market information does not exist, the entity may use its
own entity-specific assumptions, but it would modify those assumptions to remove any
entity-specific characteristics (i.e., synergies) or expertise not available to other market
participants. For example, any asymmetry of information where a reporting entity has
information about an asset or liability that is not available to market participants, even
through the market participants’ due diligence efforts, would not be reflected in the
determination of fair value. ASC Subtopic 820-10 specifies that measurements based
only on entity-specific assumptions, if those assumptions are contrary to, or not all-
inclusive of, assumptions that market participants are expected to use, are not consistent
with the fair value measurement objective.
16.026 ASC Subtopic 820-10 states that it is reasonable to assume that a market
participant that is both able and willing to transact for an asset or liability would
undertake efforts necessary to understand all of the rights and obligations inherent in the
asset or liability based on all available information and would factor any related risks into
the fair value measurement.
16.027 Risks that are considered in fair value measurements include market,
nonperformance (including credit), liquidity, and volatility risk. Fair value measurements
should consider the assumptions of market participants related to the asset or liability’s
utility and related future cash flows, including the risks and uncertainties surrounding
those cash flows and the amount that market participants would demand for bearing those
risks and uncertainties. For example, an entity applies a liquidity factor when measuring
the fair value of a particular financial instrument if it believes market participants would
apply such a factor, even in circumstances in which the entity deems such a factor
unnecessary for its own purposes. Similarly, an entity should consider a risk-adjusted
discount rate that is deemed appropriate by market participants even when the entity
believes its inherent risk is lower for that financial instrument as compared to other
market participants due to the entity’s specific expertise.
MARKET PARTICIPANTS – STRATEGIC AND FINANCIAL BUYERS
16.028 When identifying the characteristics of market participants for a particular asset or
liability, an entity should consider whether the market participants are strategic or
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financial buyers. Strategic buyers are considered buyers that have related,
complementary, or substitute assets to the subject asset, while financial buyers do not.
Fair value measurements may differ depending on whether the market participants for a
particular asset or liability are strategic or financial buyers, reflecting, for instance,
different uses for an asset and different operating strategies among the market participant
buyers within those groups. In determining whether the market participants are strategic
or financial buyers, it is important to consider the highest and best use of the asset (see
Application to Nonfinancial Assets - Highest and Best Use in this Section for additional
discussion).
Example 16.3: Strategic and Financial Buyers (Highest and Best Use)
ABC Corp., a strategic buyer, acquires a group of assets (Assets A, B, and C) from DEF
Corp. in a business combination. Asset C is billing software developed by DEF for its
own use in conjunction with Assets A and B (related assets). ABC measures the fair
value of each of the assets individually, consistent with the specified unit of account for
the assets. ABC determines that each asset would provide maximum value to market
participants principally through its use in combination with other assets as a group
(highest and best use is in combination with other assets as a group).
In this instance, the market in which ABC sells the assets is the market in which it
initially acquired the assets (that is, the entry and exit markets from the perspective of
ABC are the same). Market participant buyers with whom ABC transacts in that market
have characteristics that are representative of both financial buyers and strategic buyers
and include those buyers that initially bid for the assets. As discussed below, differences
between the indicated fair values of the individual assets relate principally to the use of
the assets by those market participants within different asset groups:
(a) Strategic buyer asset group. ABC, as a strategic buyer, determines that
strategic buyers have related assets that would enhance the value of the group
within which the assets would be used (market participant synergies). The
assets include a substitute asset for Asset C (the billing software), which
would be used for only a limited transition period and could not be sold stand-
alone at the end of that period. Because strategic buyers have substitute assets,
Asset C would not be used for its full remaining economic life. The indicated
fair values of Assets A, B, and C within the strategic buyer asset group
(reflecting the synergies resulting from the use of the assets within that group)
are $360, $260, and $30, respectively. The indicated fair value of the assets as
a group within the strategic buyer asset group is $650.
(b) Financial buyer asset group. ABC determines that financial buyers do not
have related or substitute assets that would enhance the value of the group
within which the assets would be used. Because financial buyers do not have
substitute assets, Asset C (the billing software) would be used for its full
remaining economic life. The indicated fair values of Assets A, B, and C
within the financial buyer asset group are $300, $200, and $100, respectively.
The indicated fair value of the assets as a group within the financial buyer
asset group is $600.
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The fair values of Assets A, B, and C are determined based on the use of the assets as a
group within the strategic buyer group ($360, $260, and $30). Although the use of the
assets within the strategic buyer group does not maximize the fair value of each of the
assets individually, it maximizes the fair value of the assets as a group ($650).
ASC paragraphs 820-10-35-10E and 820-10-35-11A
APPLICATION TO NONFINANCIAL ASSETS - HIGHEST AND BEST USE
ASC Paragraph 820-10-35-10A
A fair value measurement of a nonfinancial asset takes into account a market
participant’s ability to generate economic benefits by using the asset in its highest
and best use or by selling it to another market participant that would use the asset
in its highest and best use.
ASC Paragraph 820-10-35-10B
The highest and best use of a nonfinancial asset takes into account the use of the
asset that is physically possible, legally permissible, and financially feasible as
follows:
a. A use that is physically possible takes into account the physical
characteristics of the asset that market participants would take into account
when pricing the asset (for example, the location or size of a property).
b. The use that is legally permissible takes into account any legal restrictions
on the use of the asset that market participants would take into account when
pricing the asset (for example, the zoning regulations applicable to a
property).
c. The use that is financially feasible takes into account whether a use of the
asset that is physically possible and legally permissible generates adequate
income or cash flows (taking into account the costs of converting the asset to
that use) to produce an investment return that market participants would
require from an investment in that asset put to that use.
ASC Paragraph 820-10-35-10C
Highest and best use is determined from the perspective of market participants,
even if the reporting entity intends a different use. However, a reporting entity’s
current use of a nonfinancial asset is presumed to be its highest and best use
unless market or other factors suggest that a different use by market participants
would maximize the value of the asset.
ASC Paragraph 820-10-35-10E
The highest and best use of the nonfinancial asset establishes the valuation
premise used to measure the fair value of the asset, as follows:
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a. The highest and best use of a nonfinancial asset might provide maximum
value to market participants through its use in combination with other assets
as a group (as installed or otherwise configured for use) or in combination
with other assets and liabilities (for example, a business).
1. If the highest and best use of the asset is to use the asset in combination
with other assets or with other assets and liabilities, the fair value of the
asset is the price that would be received in a current transaction to sell the
asset assuming the asset would be used with other assets or with other
assets and liabilities and that those assets and liabilities (that is, its
complementary assets and associated liabilities) would be available to
market participants.
2. Liabilities associated with the asset and the complementary assets
include liabilities that fund working capital, but do not include liabilities
that fund assets other than those within the group of assets.
3. Assumptions about the highest and best use of a nonfinancial asset shall
be consistent for all of the assets (for which highest and best use is
relevant) of the group of assets or the group of assets and liabilities within
which the asset would be used.
b. The highest and best use of a nonfinancial asset might provide maximum
value to market participants on a standalone basis. If the highest and best use
is to use it on a standalone basis, the fair value of the asset is the price that
would be received in a current transaction to sell the asset to market
participants that would use the asset on a standalone basis.
16.029 Highest and best use is a valuation concept that refers broadly to the use of an
asset in a manner that would maximize the value of the asset or group of assets to market
participants, even if the intended use of the asset by the entity is different. A fair value
measurement assumes the highest and best use of the asset by market participants,
considering the use of the asset that is physically possible, legally permissible, and
financially feasible at the measurement date. As an example, an entity may intend to
continue the operations of a recently acquired asset in a business combination as a
manufacturing facility; if market participants consider the highest and best use of the
asset as residential property because it will produce a greater fair value, then the fair
value measurement would be considered from the perspective of market participants as
residential property rather than the entity’s intended use as a manufacturing facility. The
fair value measurement would reflect the costs and risks associated with the change to
this highest and best use. ASC paragraphs 820-10-35-10A, 35-10C, and 35-10D
16.030 The highest and best use is a valuation concept that only applies to nonfinancial
assets (e.g., real estate and intangible assets). The valuation concept of highest and best
use does not apply to liabilities as the fair value measurement for liabilities assumes the
liability is transferred to a market participant in its existing condition (including credit-
standing) at the measurement date. Additionally, the concept does not apply to financial
assets.
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16.031 Under the highest and best use valuation concept, the fair value of an asset is
measured in combination with other assets as a group or under a stand-alone valuation
premise. When the highest and best use is determined to be in combination with other
assets and liabilities as a group, the valuation premise assumes the highest and best use of
an asset will provide maximum value to market participants if combined with other assets
as a group and that those assets are already owned or are available to market participants.
The stand-alone valuation premise assumes the highest and best use of an asset will
provide maximum value to market participants if used on a stand-alone basis.
Assumptions about the highest and best use of a nonfinancial asset would need to be
consistent for all of the assets (for which highest and best use is relevant) of the group of
assets and liabilities within which the asset would be used. A reporting entity’s current
use of a nonfinancial asset is presumed to be its highest and best use unless market or
other factors suggest that a different use by market participants would maximize the
value of the asset.
16.031a See Section J in KPMG Fair Value Measurements for more discussion of
highest and best use.
Example 16.4: Highest and Best Use Valuation Premise
ABC Corp. acquires land in a business combination. The land is currently developed for
industrial use as a site for a manufacturing facility. The current use of land often is
presumed to be its highest and best use. However, nearby sites have recently been
developed for residential use as sites for high-rise condominiums. Based on that
development and recent zoning and other changes to facilitate that development, ABC
determines that the land currently used as a site for a manufacturing facility could be
developed as a site for residential use (for high-rise condominiums).
In this instance, the highest and best use of the land is determined by comparing:
(a) The fair value of the land in combination with the manufacturing operation,
which presumes that the land would continue to be used as currently
developed for industrial use (in combination with other assets as a group); and
(b) The fair value of the land as a vacant site for residential use, considering the
demolition and other costs necessary to convert the land to a vacant site
(stand-alone).
The highest and best use of the land is determined based on the higher of those values.
ASC paragraph 820-10-35-10E
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Example 16.5: In Combination with Other Assets Valuation Premise
ABC Corp. produces camera film for which the production requires a multiple-step
process whereby chemicals are applied to a cellulose material to produce the film.
Individually, the machinery necessary to produce the celluloid, along with the machinery
and other chemicals necessary to bond the materials for film production, have little or no
market value to market participants. However, the machinery taken as a group has
significant value to market participants due to the high margins resulting from the sale of
the film. In this case, the highest and best use to market participants is use of the related
assets in combination as a group.
Example 16.6: Stand-Alone Valuation Premise
DEF Corp. provides worldwide oceanic transportation services via the entity’s deep draft
cargo ships. DEF is in the process of estimating the fair value of one of its older ships for
purposes of impairment due to a new federal regulation requiring cargo ships past a
certain age to be decommissioned and removed from service. Due to a current market
slump for oceanic transportation services, the stand-alone fair value estimate is $4
million. Based on DEF’s historical experience, this fair value estimate is consistent with
how other market participants in the oceanic transportation market would value similar-
age draft cargo ships.
Oilfield drilling and production companies also use decommissioned ships as permanent
moorings to their offshore drilling and production platforms for storage, tankage, etc. The
current market price offered by several oilfield drilling and production companies to
purchase similar-age draft cargo ships is $5 million.
DEF would measure the fair value of its deep draft cargo ship using the stand-alone
valuation premise resulting in a fair value measurement of $5 million, as it represents the
highest-and-best-use for the asset. This valuation premise would be used even if DEF
does not have the current intent or ability to sell its draft cargo ship in an in-exchange
transaction.
Example 16.6a: Impact of Management's Intention on a Valuation
DEF Corp. owns and operates a chain of convenience stores. DEF often acquires single
stores, or a portfolio of stores, to rebrand and remodel them. DEF also acquires
competitor stores as a strategy to remove them from the market.
DEF enters into an agreement with ABC Corp. (a competitor) to purchase one of ABC's
convenience stores with the intention of closing it, placing a deed restriction on the
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property that prohibits it from being used to operate a convenience store, and reselling the
property.
When estimating the fair value of the property, DEF should apply the highest and best
use concept and not consider management's intent to place a restriction on the deed and
resell it. Therefore, assuming the highest and best use by a market participant is the
continued operation of the store, DEF's estimate of the fair value of the property should
reflect that assumption.
Application to Liabilities and Instruments Classified in a Reporting Entity’s
Shareholders’ Equity
ASC Paragraph 820-10-35-16
A fair value measurement assumes that a financial or nonfinancial liability or an
instrument classified in a reporting entity’s shareholders’ equity (for example,
equity interests issued as consideration in a business combination) is transferred
to a market participant at the measurement date. The transfer of a liability or an
instrument classified in a reporting entity’s shareholders’ equity assumes the
following:
a. Subparagraph superseded by Accounting Standards Update No. 2011-04.
b. A liability would remain outstanding and the market participant transferee
would be required to fulfill the obligation. The liability would not be settled
with the counterparty or otherwise extinguished on the measurement date.
c. An instrument in a reporting entity’s stockholders’ equity would remain
outstanding and the market participant transferee would take on the rights and
responsibilities associated with the instrument. The instrument would not be
cancelled or otherwise extinguished on the measurement date.
16.032 The fair value of a liability is the price that would be paid to transfer it to a market
participant at the measurement date. The fair value measurement of a liability assumes
that the liability is not settled with the counterparty and the obligation continues with the
market participant. Because the liability is assumed to be transferred to a market
participant and the liability continues to exist, the fair value measurement also should
consider the effect of nonperformance risk (i.e., the risk the obligation will not be
fulfilled). In accordance with ASC Subtopic 820-10, the nonperformance risk associated
with the liability is assumed to be the same before and after its transfer. Nonperformance
risk affects the price at which a liability would be transferred. Therefore, the fair value of
a liability should reflect the nonperformance risk for that liability at the measurement
date.
16.033 Nonperformance risk includes, but may not be limited to, the entity’s own credit
risk. The effect of nonperformance risk (e.g., credit standing) on the fair value of a
liability may differ depending on the liability. For example, a liability that represents an
obligation to deliver cash (a financial liability) may have a different nonperformance risk
than an obligation to deliver goods or services (a nonfinancial liability). Additionally, the
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terms of credit enhancements related to the liability, if any, will affect its nonperformance
risk.
16.034 When a quoted price for the transfer of an identical or a similar liability or
instrument classified in a reporting entity’s shareholders’ equity is not available, and the
identical item is held by another party as an asset, a reporting entity would measure the
fair value of the liability or equity instrument from the perspective of a market participant
that holds the identical item as an asset at the measurement date. In these cases, a
reporting entity would measure the fair value of the liability or equity instrument as
follows:
(1) Using the quoted price in an active market for the identical item held by
another party as an asset, if that price is available.
(2) If that price is not available, using other observable inputs, such as the quoted
price in a market that is not active for the identical item held by another party
as an asset.
(3) If the observable prices are not available, using another valuation approach,
such as an income or market approach. ASC paragraph 820-10-35-16BB
16.035 The holder of an instrument as an asset incorporates nonperformance risk in the
measurement of fair value. Because fair value assumes the transfer, rather than the
settlement, of a liability, the issuer of the instrument likewise should include
nonperformance risk in its measurement of fair value. Consideration of nonperformance
risk in the measurement of a liability results in symmetry in the fair value measurement
for a financial liability between the issuer and the holder. That is, to the issuer, the
instrument is a liability, but to the holder, the instrument is an asset. If both parties have
access to the same market and have similar views about market participants and their
related assumptions, then it is reasonable to expect that both parties would arrive at
substantially the same fair value measurement for the instrument. A reporting entity
should adjust the quoted price of a liability or an instrument classified in a reporting
entity’s shareholders’ equity held by another party as an asset only if there are factors
specific to the asset that are not applicable to the fair value measurement of the liability
or equity instrument.
Example 16.7: Effect of Nonperformance Risk on the Fair Value of a
Liability
ABC Corp. and DEF Corp. each enter into a contractual obligation to pay cash ($500) to
GHI Corp. in 5 years. ABC has an AA credit rating and can borrow at 6%, while DEF
has a BBB credit rating and can borrow at 12%. ABC receives about $374 in exchange
for its promise (the present value of $500 in 5 years at 6%). DEF receives about $284 in
exchange for its promise (the present value of $500 in 5 years at 12%).
The fair value of the liability to each entity (the proceeds) incorporates that entity’s credit
standing.
ASC paragraphs 820-10-55-56 through 55-58
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16.036 Measuring the fair value of debt that is not actively traded, for example, notes
payable to a lender, typically requires the use of valuation approaches. Although different
valuation approaches may be appropriate, a common approach used is the income
approach. Specifically, cash flows attributable to the obligation, including future
payments of principal and interest, are discounted to present value from the payment
dates back to the fair value measurement date, using a discount rate reflective of the risk
of the cash flows, including nonperformance risk. Nonperformance risk captures the
credit risk associated with the obligor, which may have characteristics of the
creditworthiness of the acquirer, the acquiree, or a blending of the two. If an identical
item is held by another party as an asset, the reporting entity may apply an income
approach that takes into account the future cash flows that a market participant would
expect to receive from holding the liability or equity instrument as an asset.
Example 16.8: Non-Actively Traded Debt Instrument
DEF Corp., a private retail distribution entity, has one primary debt issue outstanding
with a consortium of banks. The debt issue, which had an original maturity of 30 years,
currently has 10 years remaining to maturity. Due to a recent credit downgrade by DEF’s
primary rating agency, DEF’s cost of borrowing has significantly increased. Specifically,
based on discussions with its primary bank, DEF determines the current spread (credit
and liquidity) above the risk-free rate for its obligations is approximately 700 basis
points.
For most debt issuances, the interest rate on new issuances is determined by adding the
pre-determined credit spread required by the debt underwriters to a risk-free market rate
(usually the treasury rate that matches the term of the proposed issuance).
Assuming the current interest rate for a 10-year Treasury Bill (10 years is the length of
time until maturity of the debt issue being evaluated) is 5%, then the current interest rate
for any new DEF obligations is estimated to be 12%. To determine the fair value of its
existing debt at the measurement date, DEF discounts all future cash flows attributable to
the debt, including contractual interest payments at the stated rate of the debt, and
contractual principal payments, adjusted for prepayment considerations, to the
measurement date using a 12% discount rate. This discounted amount represents the
estimated fair value for the debt instrument at the measurement date.
FAIR VALUE AT INITIAL RECOGNITION
ASC Paragraph 820-10-30-2
When an asset is acquired or a liability is assumed in an exchange transaction for
that asset or liability, the transaction price is the price paid to acquire the asset or
received to assume the liability (an entry price). In contrast, the fair value of the
asset or liability is the price that would be received to sell the asset or paid to
transfer the liability (an exit price). Entities do not necessarily sell assets at the
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prices paid to acquire them. Similarly, entities do not necessarily transfer
liabilities at the prices received to assume them.
16.037 A transaction price represents the price paid to acquire an asset or received to
assume a liability. There are many questions whether a transaction price in an actual
transaction represents the fair value of an asset or liability at initial recognition. FASB
Concepts Statement No. 7, Using Cash Flow Information and Present Value in
Accounting Measurements, states that “at initial recognition, the cash or equivalent
amount paid or received (historical cost or proceeds) is usually assumed to approximate
fair value, absent evidence to the contrary.” This concept is an entry price notion.
16.038 Under ASC Subtopic 820-10, fair value is defined as the price received to sell an
asset currently or paid to transfer a liability in an orderly transaction between market
participants in the principal (or most advantageous) market for that asset or liability at the
measurement date. That is, fair value is based on an exit price notion considered from the
perspective of a market participant that is prepared to buy an asset from an entity or
willing to accept an entity’s performance obligation for its liability.
16.039 Conceptually, entry and exit prices are different. Entities do not necessarily sell or
transfer assets or liabilities at the prices paid to acquire or assume them, respectively.
However, in certain cases the transaction price (entry price) may equal the exit price and,
therefore, could provide evidence of the fair value of the asset or liability at initial
recognition.
16.040 ASC Subtopic 820-10 includes several examples of factors an entity should
consider in determining whether a transaction price provides evidence of the fair value of
an asset or liability at initial recognition. For example, a transaction price might not
provide evidence of the fair value of an asset or liability at initial recognition if:
(a) The transaction is between related parties. Although the transaction price
might be used as an input to the fair value measurement if the reporting entity
has evidence to support a conclusion that the transaction was entered into at
market terms.
(b) The transaction occurs under duress or the seller is forced to accept the price
in the transaction. For example, if the seller is experiencing financial difficulty
and therefore cannot wait the customary time it would take to market and sell
the asset.
(c) The unit of account represented by the transaction price is different from the
unit of account for the asset or liability measured at fair value. For example, if
the asset or liability measured at fair value is only one of the elements in the
transaction, the transaction includes unstated rights and privileges that should
be separately measured, or the transaction price includes transaction costs.
(d) The market in which the transaction takes place is different from the principal
or most advantageous market for the asset or liability. For example, those
markets might be different if the entity is a securities dealer that transacts in
different markets, depending on whether the counterparty is a retail customer
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(retail market) or another securities dealer (inter-dealer market) while the
principal (or most advantageous) market for the exit transaction is with other
dealers. ASC paragraphs 820-10-30-3 through 30-3A
VALUATION APPROACHES
ASC Paragraph 820-10-35-24A
The objective of using a valuation technique is to estimate the price at which an
orderly transaction to sell the asset or to transfer the liability would take place
between market participants at the measurement date under current market
conditions. Three widely used valuation approaches are the market approach, cost
approach, and income approach. The main aspects of valuation techniques
consistent with those approaches are summarized in [ASC] paragraphs 820-10-
55-3A through 55-3G. An entity shall use valuation techniques consistent with
one or more of those approaches to measure fair value.
Market Approach
ASC Paragraph 820-10-55-3A
The market approach uses prices and other relevant information generated by
market transactions involving identical or comparable (that is, similar) assets,
liabilities, or a group of assets and liabilities, such as a business.
ASC Paragraph 820-10-55-3B
For example, valuation techniques consistent with the market approach often use
market multiples derived from a set of comparables. Multiples might be in ranges
with a different multiple for each comparable. The selection of the appropriate
multiple within the range requires judgment, considering qualitative and
quantitative factors specific to the measurement.
ASC Paragraph 820-10-55-3C
Valuation techniques consistent with the market approach include matrix pricing.
Matrix pricing is a mathematical technique used principally to value some types
of financial instruments, such as debt securities, without relying exclusively on
quoted prices for the specific securities, but rather relying on the securities’
relationship to other benchmark quoted securities.
Cost Approach
ASC Paragraph 820-10-55-3D
The cost approach reflects the amount that would be required currently to replace
the service capacity of an asset (often referred to as current replacement cost).
ASC Paragraph 820-10-55-3E
From the perspective of a market participant seller, the price that would be
received for the asset is based on the cost to a market participant buyer to acquire
or construct a substitute asset of comparable utility, adjusted for obsolescence.
That is because a market participant buyer would not pay more for an asset than
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the amount for which it could replace the service capacity of that asset.
Obsolescence encompasses physical deterioration, functional (technological)
obsolescence, and economic (external) obsolescence and is broader than
depreciation for financial reporting purposes (an allocation of historical cost) or
tax purposes (using specified service lives). In many cases, the current
replacement cost method is used to measure the fair value of tangible assets that
are used in combination with other assets or with other assets and liabilities.
Income Approach
ASC Paragraph 820-10-55-3F
The income approach converts future amounts (for example, cash flows or income
and expenses) to a single current (that is, discounted) amount. When the income
approach is used, the fair value measurement reflects current market expectations
about those future amounts.
ASC Paragraph 820-10-55-3G
Those valuation techniques include, for example, the following:
a. Present value techniques
b. Option-pricing models, such as the Black-Scholes-Merton formula or a
binomial model (that is, a lattice model), that incorporate present value
techniques and reflect both the time value and the intrinsic value of an option
c. The multiperiod excess earnings method, which is used to measure the fair
value of some intangible assets.
16.041 The next step in measuring fair value for financial reporting purposes is to
determine the appropriate valuation technique, or combination of valuation techniques, to
use when measuring fair value. ASC Subtopic 820-10 requires all measurements of fair
value to use techniques that are consistent with one or more of the three following
valuation approaches: market approach, income approach, and cost approach (see also
KPMG Fair Value Measurements Q&A F10 for additional examples of these approaches
beyond those discussed below).
MARKET APPROACH
16.042 The market approach uses prices and other relevant information generated by
reference to market transactions involving identical or comparable assets or liabilities
(including a business). Valuation techniques under the market approach often use market
multiples (e.g., a Price-to-Earnings (P/E) multiple, a multiple of EBITDA, or a price per
square foot) derived from a set of comparable transactions. Market multiples from
comparable transactions often will indicate a range of possible valuations and the
selection within the range requires judgment, considering factors specific to the
measurement (qualitative and quantitative), and assumptions of market participants. A
fair value measurement is the point within that range that is most representative of fair
value in the circumstances.
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INCOME APPROACH
16.043 Under the income approach, fair value is determined by converting future
amounts (e.g., cash flows or earnings) to a single present amount. One of the most
common valuation techniques under the income approach is the discounted cash flow
method. Under that method, the entity first estimates the net cash flows expected to
accrue directly or indirectly resulting from ownership of the asset. Second, the entity
discounts those future cash flows to their present value using an appropriate discount rate
converting the cash flows or earnings to a single present amount. Variations of the
discounted cash flow method are often used to value intangible assets, including: the
multi-period excess earnings method, the relief from royalty method, and the incremental
cash flow method. A key component in any discounted cash flow technique is the
discount rate and, generally, the discount rate should be commensurate with the risk
associated with the cash flows reflecting market participant expectations of risk and
return for the particular asset or liability. ASC Section 820-10-55 provides additional
guidance on the application of present value techniques in a fair value measurement.
Other common valuation techniques under the income approach are option-pricing
models, such as the Black-Scholes-Merton formula, which is a closed-form model, and
binomial models (e.g., a lattice model).
COST APPROACH
16.044 The cost approach establishes a value based on the cost of reproducing or
replacing the asset, often referred to as current replacement cost. From the perspective of
a market participant, the price received for an asset is estimated based on the cost to a
market participant to reproduce or to replace the asset with a substitute asset of
comparable utility. For nonfinancial assets, the valuation process under the cost approach
typically begins with an estimation of the asset’s replacement cost adjusted, where
applicable, for obsolescence to estimate the replacement cost of the asset’s current
service potential. Obsolescence includes physical depreciation, functional or
technological obsolescence, and economic obsolescence.
16.045 ASC Subtopic 820-10 emphasizes that valuation techniques used to measure fair
value should be appropriate for the circumstances and should be consistent with the
market approach, income approach, and/or cost approach. A single valuation approach is
appropriate in certain circumstances. For example, when valuing an asset or liability
using quoted prices in an active market for identical assets or liabilities, a market
approach is most appropriate. In other cases, multiple valuation approaches may be
appropriate. For example, when estimating the fair value of a reporting unit, both a
market approach and an income approach may be appropriate. ASC paragraph 820-10-
35-24
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Example 16.9: Income vs. Cost Approaches – Software Asset
ABC Corp. acquires a group of assets. The asset group includes an income-producing
software asset internally developed for licensing to customers and its complementary
assets (including a related database with which the software asset is used) and the
associated liabilities. For purposes of measuring the fair value of the software asset, ABC
determines that the software asset provides maximum value to market participants
through its use in combination with other assets or with other assets and liabilities (that is,
its complementary assets and associated liabilities). There is no evidence to suggest that
the current use of the software asset is not the highest and best use. Therefore, the highest
and best use of the software asset is in its current use. (In this case, the licensing of the
software asset, in and of itself, does not indicate that the fair value of the asset would be
maximized through its use by market participants on a stand-alone basis.)
ABC determines that in addition to the income approach, sufficient data may be available
to apply the cost approach but not the market approach. Information about market
transactions for comparable software assets is not available. The income and cost
approaches are applied as follows:
(a) Income approach. The income approach is applied using a present value
technique. The cash flows used in that technique reflect the income stream
expected to result from the software asset (license fees from customers) over
its economic life. The fair value indicated is $15 million.
(b) Cost approach. The cost approach is applied using a replacement cost method
by estimating the amount that currently would be required to construct a
substitute software asset of comparable utility (considering functional,
technological, and economic obsolescence). The fair value indicated is $10
million.
Through its application of the cost approach, ABC determines that market participants
are unable to replicate a substitute software asset of comparable utility. Certain attributes
of the software asset are unique, having been developed using proprietary information,
and cannot be readily replicated. ABC determines that the fair value of the software asset
is $15 million, as indicated by the income approach.
ASC paragraphs 820-10-55-39 through 41
16.046 If multiple valuation techniques are used to measure fair value, the results of each
should be evaluated and weighted, as appropriate, in determining fair value. In making
that evaluation, an entity should consider, among other things, the reliability of the
valuation techniques applied and the related inputs that are used in those techniques. If a
particular market approach relies on higher level inputs (e.g., Level 1 – observable
market prices) compared to a particular income approach that relies heavily on
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unobservable inputs (e.g., Level 3 – cash flow projections), the entity should apply
greater weight to the market approach to maximize the use of observable inputs.
16.047 ASC Subtopic 820-10 does not provide guidance for a particular weighting
exercise if multiple approaches or techniques are used. Instead, judgment is required
depending on the circumstances and available information. If multiple valuation
approaches are used, a fair value measurement is the point within the range that is most
representative of fair value under the circumstances.
16.048 ASC Subtopic 820-10 emphasizes that valuation approaches and techniques used
to measure fair value should be consistently applied. However, a change in a valuation
technique is appropriate if the change results in a measurement that is more
representative of fair value in the circumstances. Examples include development of new
markets, new information becoming available, information previously used is no longer
available, or valuation techniques improve. Revisions resulting from a change in the
valuation technique should be accounted for prospectively as a change in accounting
estimate under ASC Topic 250, Accounting Changes and Error Corrections. ASC
paragraphs 820-10-35-25 and 35-26, 50-7, 65-2, and 250-10-50-5
16.049 ASC Subtopic 820-10 does not provide specific requirements for selecting an
appropriate valuation technique or techniques for measuring fair value. The appropriate
valuation technique or techniques depends on the value drivers, the reliability of inputs,
and market participants. While ASC Subtopic 820-10 does not provide specific
guidelines for determining the appropriate valuation technique, it establishes a fair value
hierarchy that prioritizes fair value measurements based on the significance of observable
inputs.
VALUATION ANALYSIS INPUTS
ASC Paragraph 820-10-35-36
Valuation techniques used to measure fair value shall maximize the use of
relevant observable inputs and minimize the use of unobservable inputs.
ASC Paragraph 820-10-35-36B
A reporting entity shall select inputs that are consistent with the characteristics of
the asset or liability that market participants would take into account in a
transaction for the asset or liability (see [ASC] paragraphs 820-10-35-2B through
35-2C). In some cases, those characteristics result in the application of an
adjustment, such as a premium or discount (for example, a control premium or
noncontrolling interest discount). However, a fair value measurement shall not
incorporate a premium or discount that is inconsistent with the unit of account in
the [ASC] Topic [820] that requires or permits the fair value measurement.
Premiums or discounts that reflect size as a characteristic of the reporting entity’s
holding (specifically, a blockage factor that adjusts the quoted price of an asset or
a liability because the market’s normal daily trading volume is not sufficient to
absorb the quantity held by the entity, as described in paragraph 820-10-35-44)
rather than as a characteristic of the asset or liability (for example, a control
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premium when measuring the fair value of a controlling interest) are not permitted
in a fair value measurement. In all cases, if there is a quoted price in an active
market (that is, a Level 1 input) for an asset or a liability, a reporting entity shall
use that quoted price without adjustment when measuring fair value, except as
specified in paragraph 820-10-35-41C.
ASC Master Glossary: Observable Inputs
Inputs that are developed using market data, such as publicly available
information about actual events or transactions, and that reflect the assumptions
that market participants would use when pricing the asset or liability.
ASC Master Glossary: Unobservable Inputs
Inputs for which market data are not available and that are developed using the
best information available about the assumptions that market participants would
use when pricing the asset or liability.
16.050 Inputs to valuation techniques refer to assumptions that market participants use in
pricing an asset or liability when using a valuation technique. Inputs to valuation
techniques may be either observable or unobservable when valuing an asset or liability,
including assumptions about risk. Observable inputs are inputs that reflect the
assumptions market participants use in pricing the asset or liability based on market data
that can be obtained from sources independent of the entity. The price of listed equity
securities on the New York or London Stock Exchanges are observable inputs.
Unobservable inputs are inputs that reflect the entity’s own assumptions about the
assumptions market participants would use in pricing the asset or liability based on the
best information available in the circumstances. For instance, in a business combination
using the acquisition method of accounting, observable inputs typically do not exist for
many assets acquired when there is no active market for such items. Nevertheless,
valuation techniques used to measure fair value should maximize the use of observable
inputs to the extent possible when measuring those assets and liabilities acquired and
assumed in a business combination.
16.051 ASC Subtopic 820-10 provides examples of markets in which inputs might be
observable for some assets and liabilities (e.g., financial instruments), including the
following:
(a) Exchange market. A market in which closing prices are both readily available
and generally representative of fair value. An example of such a market is the
New York Stock Exchange.
(b) Dealer market. A market in which dealers stand ready to trade (either buy or
sell for their own account), thereby providing liquidity by using their capital
to hold an inventory of items for which they make a market. Typically, bid
and ask prices (representing the price at which the dealer is willing to buy and
the price at which the dealer is willing to sell, respectively) are more readily
available than closing prices. Over-the-counter markets (for which prices are
publicly reported by the National Association of Securities Dealers
Automated Quotations systems or by Pink Sheets LLC) are dealer markets.
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For example, the market for U.S. Treasury securities is a dealer market.
Dealer markets also exist for some other assets and liabilities, including other
financial instruments, commodities, and physical assets (e.g., used
equipment).
(c) Brokered market. A market in which brokers attempt to match buyers with
sellers but do not stand ready to trade for their own account. In other words,
brokers to not use their own capital to hold an inventory of the items for
which they make a market. The broker knows the prices bid and asked by the
respective parties, but each party is typically unaware of another party’s price
requirements. Brokered markets include electronic communication networks,
in which buy and sell orders are matched, and commercial and residential real
estate markets.
(d) Principal-to-principal market. A market in which transactions, both
originations and resales, are negotiated independently with no intermediary.
Little information about those transactions may be made available publicly.
FAIR VALUE HIERARCHY
ASC Paragraph 820-10-35-37
To increase consistency and comparability in fair value measurements and related
disclosures, [ASC] Topic [820] establishes a fair value hierarchy that categorizes
into three levels (see [ASC] paragraphs 820-10-35-40 through 35-41, 820-10-35-
41B through 35-41C, 820-10-35-44, 820-10-35-46 through 35-51, and 820-10-35-
52 through 35-54A) the inputs to valuation techniques used to measure fair value.
The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in
active markets for identical assets or liabilities (Level 1 inputs) and the lowest
priority to unobservable inputs (Level 3 inputs).
16.052 ASC Subtopic 820-10 establishes a three-level fair value hierarchy that prioritizes
inputs to valuation techniques used when measuring fair value. The fair value hierarchy is
classified into Level 1, Level 2, or Level 3 and is based on the inputs used to measure fair
value. The highest priority is given to unadjusted quoted market prices (Level 1) and the
lowest priority to unobservable inputs based on the reporting entity’s judgments about the
assumptions that market participants would use in pricing the asset or liability (Level 3).
These three broad levels also provide a framework for related disclosures about fair value
measurements. Inputs to the fair value measurements should be consistent with the
assumptions that market participants would use in pricing the asset or liability, including
assumptions about risk.
16.053 In many cases, the inputs used in a particular fair value measurement technique
might fall within different levels of the fair value hierarchy. For example, an entity might
estimate the fair value of a reporting unit based on a multiple of projected earnings. In
that circumstance, the entity might be able to identify observable multiples for similar
entities, which could be considered to be Level 2 inputs. However, the earnings
projections would likely be based on the reporting entity’s judgments about the
assumptions that market participants would use in pricing the asset or liability (Level 3).
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In that circumstance, the measurement in its entirety falls within Level 3 of the hierarchy
based on the lowest level input that is significant to the fair value measurement.
16.054 The availability of market inputs relevant to the asset or liability and the relative
reliability of the inputs may affect the selection of the appropriate valuation techniques.
However, the fair value hierarchy focuses on the inputs to valuation techniques, not the
valuation techniques themselves.
LEVEL 1 INPUTS
ASC Paragraph 820-10-35-41
A quoted price in active markets provides the most reliable evidence of fair value
and shall be used without adjustment to measure fair value whenever available,
except as specified in [ASC] paragraph 820-10-35-41C.
16.055 Level 1 inputs are quoted prices in active markets. Level 1 inputs provide the
most reliable and verifiable measure of fair value and should be used whenever available.
An active market for an asset or liability is a market in which transactions for the asset or
liability occur with sufficient frequency and volume to provide pricing information on an
ongoing basis. An entity’s determination of whether a market for an asset or liability is
active is based on whether there are sufficient transactions to provide ongoing pricing
information for the asset or liability. That determination is not affected by the size of the
entity’s own position in the asset or liability that is being traded on that market. The fair
value of an asset or a liability might be affected when there has been a significant
decrease in the volume or level of activity for that asset or liability in relation to normal
market activity for the asset or liability. To determine whether, on the basis of the
evidence available, there has been a significant decrease in the volume or level of
activity, a reporting entity should consider factors such as those listed in ASC paragraph
820-10-35-54C.
16.056 The existence of observable quoted prices in active markets for identical assets or
liabilities generally preclude the use of other valuation techniques (e.g., internal valuation
models) that may result in a different fair value measurement. ASC Subtopic 820-10
emphasizes that valuation techniques used to measure fair value maximize the use of
observable inputs and the existence of Level 1 inputs for an asset or liability generally
precludes the use of lower level inputs in a valuation technique. For example, assume
Entity A holds an option to acquire common shares of Entity B, a public company with
actively traded shares on the New York Stock Exchange. Entity A’s option to acquire
common shares of Entity B is not actively traded; thus, to perform a fair value
measurement of the share option, Entity A uses a valuation technique (e.g., Black-
Scholes-Merton formula). A required input to the Black-Scholes-Merton formula is the
share price (i.e., closing price) of Entity B’s common shares, a Level 1 input, at the
measurement date. Entity A would use the closing price rather than using a lower level
input for Entity B’s share price, such as Entity A’s discounted cash flow analysis for a
contemplated tender offer of Entity B’s common shares.
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16.057 ASC Subtopic 820-10 provides an exception to the required use of Level 1 inputs
in situations when a reporting entity holds a large number of similar (but not identical)
assets or liabilities measured at fair value and a quoted price for an identical asset or
liability in an active market is available, but it is not readily accessible for each of those
assets or liabilities individually. In that case, as a practical expedient, a reporting entity
may measure the fair value of the asset or liability using an alternative pricing method
that does not rely exclusively on quoted prices (e.g., matrix pricing). However, the use of
an alternative pricing method results in a fair value measurement categorized within a
lower level of the fair value hierarchy. ASC subparagraph 820-10-35-41C(a)
16.058 The FASB provided the above exception as a practical measure for holders of a
large number of assets or liabilities (e.g., debt securities) that require those holders to
subscribe to multiple data services and perform extensive research for actively traded
prices for each asset or liability held in its portfolios. Generally, this exception can only
be used when all of the following criteria are met:
• The entity holds a large number of similar assets or liabilities (i.e.,
homogenous assets or liabilities);
• Quoted prices from an active market are not readily accessible for each of the
individual assets or liabilities, without undue cost or effort; and
• The use of the alternative pricing method results in a price that the entity
believes it would receive to sell an asset or pay to transfer a liability in an
orderly transaction with market participants at the measurement date.
16.059 In rare circumstances, a quoted price in an active market might not be
representative of the fair value of a particular asset or liability at the measurement date.
Adjustments to Level 1 inputs may be necessary. However, adjustments to Level 1 inputs
should only occur in limited circumstances and will result in a fair value measurement
categorized within a lower level of the fair value hierarchy. ASC paragraph 820-10-35-
41C states three situations in which an adjustment to the quoted price is allowed:
• When a reporting entity holds a large number of similar (but not identical)
assets or liabilities that are measured at fair value and a quoted price in an
active market is available but not readily accessible (discussed in Paragraph
16.057 above);
• Significant events (such as transactions in a principal-to-principal market,
trades in a brokered market, or announcements) that take place after the close
of the applicable market but before the measurement date; and
• When measuring the fair value of a liability or an instrument classified in a
reporting entity’s shareholders’ equity using the quoted price for the identical
item traded as an asset in an active market and that price needs to be adjusted
for factors specific to the item or the asset. If no adjustment to the quoted
price of the asset is required, the result is a fair value measurement
categorized within Level 1 of the fair value hierarchy. However, any
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adjustment to the quoted price of the asset results in a fair value measurement
categorized within a lower level of the fair value hierarchy.
16.060 Adjustments to Level 1 measures for other reasons (e.g., temporary market
conditions, other reserves, or blockage factors) are not permitted. For instance, the FASB
considered whether the appropriate unit of account for a block position in an instrument
that trades in an active market is (1) at the individual trading unit where the fair value
measurement would be determined as a product of the quoted price of the individual
security (P × Q) or (2) the block where the fair value measurement would be determined
using the quoted price, adjusted for the size of the position relative to trading volume
(i.e., blockage factor). In that instance, where there is a Level 1 price for an individual
unit of a block of securities, the aggregated block of securities would be valued as the
product of the Level 1 price (unadjusted) multiplied by the quantity of instruments held
by the entity at the measurement date (P × Q), excluding consideration of blockage
factors. ASC paragraph 805-10-35-36B
LEVEL 2 INPUTS
ASC Paragraph 820-10-35-47
Level 2 inputs are inputs other than quoted prices included within Level 1 that are
observable for the asset or liability, either directly or indirectly.
ASC Paragraph 820-10-35-48
If the asset or liability has a specified (contractual) term, a Level 2 input must be
observable for substantially the full term of the asset or liability. Level 2 inputs
include the following:
a. Quoted prices for similar assets or liabilities in active markets
b. Quoted prices for identical or similar assets or liabilities in markets that are
not active
c. Inputs other than quoted prices that are observable for the asset or liability,
for example:
1. Interest rates and yield curves observable at commonly quoted intervals
2. Implied volatilities
3. Subparagraph superseded by Accounting Standards Update No. 2011-
04
4. Subparagraph superseded by Accounting Standards Update No. 2011-
04
5. Credit spreads.
6. Subparagraph superseded by Accounting Standards Update No. 2011-
04
d. Market-corroborated inputs.
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16. Overview of ASC Subtopic 820-10
16.061 Level 2 inputs are inputs other than quoted prices included within Level 1 that are
observable for the asset or liability, either directly or indirectly through corroboration
with observable market data. If the asset or liability has a specified contractual term, a
Level 2 input should be observable for substantially the full term of the asset or liability.
16.062 Determining if a Level 2 input is observable for substantially the full term of the
asset or liability requires judgment. For instance, fair value measurements that use
multiple future data points, such as debt involving interpolated yield curve data or over-
the-counter commodity forward contracts involving forward curves, should match the
term of the asset or liability being measured and also be observable for substantially the
entire term of the asset or liability to qualify as Level 2 inputs. It is generally
inappropriate to use a 10-year Treasury rate as an input for measuring the fair value of a
debt instrument with either an 8-year term or a 12-year term, unless that Level 2 input has
been adjusted for the difference in the terms between the reference rate and the term of
the debt instrument.
16.063 Adjustments to Level 2 inputs will vary depending on factors specific to the asset
or liability. Those factors include the condition or location of the asset, the extent to
which inputs relate to items that are comparable to the asset, and the volume or level of
activity in the markets within which the inputs are observed. Adjustments to a Level 2
input that are significant to the entire measurement might result in a fair value
measurement categorized within Level 3 of the fair value hierarchy if the adjustment uses
significant unobservable inputs.
16.064 ASC Subtopic 820-10 provides the following examples of Level 2 inputs for
particular assets and liabilities:
(a) Receive-fixed, pay-variable interest rate swap based on the London Interbank
Offered Rate (LIBOR) swap rate. A Level 2 input would be the LIBOR swap
rate if that rate is observable at commonly quoted intervals for the full term of
the swap.
(b) Receive-fixed, pay-variable interest rate swap based on a yield curve
denominated in a foreign currency. A Level 2 input would be the swap rate
based on a yield curve denominated in a foreign currency that is observable at
commonly quoted intervals for substantially the full term of the swap. That
would be the case if the term of the swap is 10 years and that rate is
observable at commonly quoted intervals for 9 years, provided that any
reasonable extrapolation of the yield curve for year 10 would not be
significant to the fair value measurement of the swap in its entirety.
(c) Receive-fixed, pay-variable interest rate swap based on a specific bank’s
prime rate. A Level 2 input would be the bank’s prime rate derived through
extrapolation if the extrapolated values are corroborated by observable market
data, for example, by correlation with an interest rate that is observable over
substantially the full term of the swap.
(d) Three-year option on exchange-traded shares. A Level 2 input would be the
implied volatility for the shares derived through extrapolation to year 3 if (1)
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16. Overview of ASC Subtopic 820-10
prices for one-year and two-year options on the shares are observable and (2)
the extrapolated implied volatility of a three-year option is corroborated by
observable market data for substantially the full term of the option. In that
case, the implied volatility could be derived by extrapolating from the implied
volatility of the one-year and two-year options on the shares and corroborated
by the implied volatility for three-year options on comparable entities’ shares,
provided that correlation with the one- and two-year implied volatilities is
established.
(e) Licensing arrangement. For a licensing arrangement that is acquired in a
business combination and that was recently negotiated with an unrelated party
by the acquired entity (the party to the licensing arrangement), a Level 2 input
would be the royalty rate in the contract with the related party at inception of
the arrangement.
(f) Finished goods inventory at a retail outlet. For finished goods inventory that
is acquired in a business combination, a Level 2 input would be either a price
to customers in a retail market or a price to retailers in a wholesale market,
adjusted for differences between the condition and location of the inventory
item and the comparable (that is, similar) inventory items so that the fair value
measurement reflects the price that would be received in a transaction to sell
the inventory to another retailer that would complete the requisite selling
efforts. Conceptually, the fair value measurement will be the same, whether
adjustments are made to a retail price (downward) or to a wholesale price
(upward). Generally, the price that requires the least amount of subjective
adjustments should be used for the fair value measurement.
(g) Building held and used. A Level 2 input would be the price per square foot for
the building (a valuation multiple) derived from observable market data, for
example, multiples derived from prices in observed transactions involving
comparable (that is, similar) buildings in similar locations.
(h) Reporting unit. A Level 2 input would be a valuation multiple (e.g., a multiple
of earnings or revenue or a similar performance measure) derived from
observable market data (e.g., multiples derived from prices in observed
transactions involving comparable (that is, similar) businesses, taking into
account operational, market, financial, and nonfinancial factors). ASC
paragraph 820-10-55-21
LEVEL 3 INPUTS
ASC Paragraph 820-10-35-52
Level 3 inputs are unobservable inputs for the asset or liability.
ASC Paragraph 820-10-35-53
Unobservable inputs shall be used to measure fair value to the extent that relevant
observable inputs are not available, thereby allowing for situations in which there
is little, if any, market activity for the asset or liability at the measurement date.
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16. Overview of ASC Subtopic 820-10
However, the fair value measurement objective remains the same, that is, an exit
price at the measurement date from the perspective of a market participant that
holds the asset or owes the liability. Therefore, unobservable inputs shall reflect
the assumptions that market participants would use when pricing the asset or
liability, including assumptions about risk.
ASC Paragraph 820-10-35-54A
A reporting entity shall develop unobservable inputs using the best information
available in the circumstances, which might include the reporting entity’s own
data. In developing unobservable inputs, a reporting entity may begin with its own
data, but it shall adjust those data if reasonably available information indicates
that other market participants would use different data or there is something
particular to the reporting entity that is not available to other market participants
(for example, an entity-specific synergy). A reporting entity need not undertake
exhaustive efforts to obtain information about market participant assumptions.
However, a reporting entity shall take into account all information about market
participant assumptions that is reasonably available. Unobservable inputs
developed in the manner described above are considered market participant
assumptions and meet the objective of a fair value measurement.
16.065 Level 3 inputs are unobservable inputs for an asset or liability. That is, inputs that
reflect an entity’s own estimates about the assumptions market participants would use in
pricing the asset or liability, including assumptions about risk, which have been
developed based on the best information available in the circumstances (including the
entity’s own data). Although Level 3 inputs are not obtained from observable market
data, the fair value measurement objective remains the same - an exit price notion
reflecting the assumptions of market participants.
16.066 Unobservable inputs should be used to measure fair value only when observable
inputs are not available. When developing unobservable inputs, an entity is not required
to undertake all possible efforts to obtain information about market participant
assumptions. However, the entity cannot ignore information about market participant
assumptions that is reasonably available without undue cost and effort. The entity’s own
data used to develop unobservable inputs is adjusted if information indicates that market
participants would use the adjusted assumptions and the information is reasonably
available without undue cost and effort.
16.067 ASC Subtopic 820-10 provides the following examples of Level 3 inputs for
particular assets and liabilities:
(a) Long-dated currency swap. A Level 3 input would be an interest rate in a
specified currency that is not observable and cannot be corroborated by
observable market data at commonly quoted intervals or otherwise for
substantially the full term of the currency swap. The interest rates in a
currency swap are the swap rates calculated from the respective countries’
yield curves.
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16. Overview of ASC Subtopic 820-10
(b) Three-year option on exchange-traded shares. A Level 3 input would be
historical volatility, that is, the volatility for the shares derived from the
shares’ historical prices. Historical volatility typically does not represent
current market participants’ expectations about future volatility, even if it is
the only information available to price an option.
(c) Interest rate swap. A Level 3 input would be an adjustment to a mid-market
consensus (nonbinding) price for the swap developed using data that are not
directly observable and cannot otherwise be corroborated by observable
market data.
(d) Asset retirement obligation at initial recognition. Level 3 inputs are typically
used in applying an expected present value technique. An entity estimates
future cash flows based on market participants’ expectations about the costs of
fulfilling the obligation and the compensation that a market participant would
require for taking on the asset retirement obligation. A credit-adjusted risk-
free rate is used to discount those future cash flows to estimate fair value.
(e) Reporting unit. A Level 3 input would be a financial forecast (e.g., of cash
flows or earnings) developed using the entity’s own data if there is no
reasonably available information that indicates that market participants would
use different assumptions. ASC paragraph 820-10-55-22
INPUTS BASED ON BID AND ASK PRICES
ASC Paragraph 820-10-35-36C
If an asset or a liability measured at fair value has a bid and an ask price (for
example, an input from a dealer market), the price within the bid-ask spread that
is most representative of fair value in the circumstances shall be used to measure
fair value regardless of where the input is categorized within the fair value
hierarchy (that is, Level 1, 2, or 3). The use of bid prices for asset positions and
ask prices for liability positions is permitted but is not required.
16.068 Certain markets for assets and liabilities function such that market prices are
quoted in terms of bid and ask prices. Bid and ask prices are common in dealer markets
that involve sales and purchases of assets or liabilities between dealers in a particular
market. In such markets, the bid price represents the last offer to purchase a particular
asset or assume a liability, and the ask price represents the last offer to sell an asset or
transfer a liability. The difference between the bid and the ask price is referred to as the
bid-ask spread. The price paid for the asset or liability is at a value within the boundaries
of the bid-ask spread.
16.069 If an input used to measure fair value is based on bid and ask prices, the price
within the bid-ask spread that is most representative of fair value in the circumstances
should be used to measure fair value within all levels of the fair value hierarchy provided
that the price is consistently determined.
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16. Overview of ASC Subtopic 820-10
16.070 ASC Subtopic 820-10 allows practical approaches for determining the appropriate
price within a bid-ask spread, including the use of a mid-market or other pricing
convention for fair value measurements based on bid and ask prices. The two most
common approaches are (1) a mid-market pricing convention, which prices all assets and
liabilities at the mean price between the bid and ask prices, or (2) the use of bid prices for
assets and ask prices for liabilities. However, entities cannot ignore available evidence
that suggests that the selected pricing convention produces an amount that is not the most
representative of fair value in the circumstances. For example, if an entity selected a mid-
market pricing convention and there is available information that suggests market
participants currently believe the most representative fair value is closer to the bid price
for an asset, then the entity should reconsider if a mid-market pricing convention is
appropriate for that specific asset in the circumstances.
DETERMINING FAIR VALUE WHEN THE VOLUME AND LEVEL OF ACTIVITY FOR
THE ASSET OR LIABILITY HAVE SIGNIFICANTLY DECREASED AND IDENTIFYING
TRANSACTIONS THAT ARE NOT ORDERLY
16.071 ASC Subtopic 820-10 provides guidance on when the volume and level of activity
for the asset or liability have significantly decreased, as well as additional guidance on
identifying circumstances that indicate a transaction is not orderly.
DETERMINING FAIR VALUE WHEN THE VOLUME AND LEVEL OF ACTIVITY FOR
THE ASSET OR LIABILITY HAVE SIGNIFICANTLY DECREASED
16.072 In accordance with ASC paragraph 820-10-35-54C, the fair value of an asset or a
liability might be affected when there has been a significant decrease in the volume or
level of activity for that asset or liability in relation to normal market activity for the asset
or liability (or similar assets or liabilities). To determine whether, on the basis of the
evidence available, there has been a significant decrease in the volume or level of activity
for that asset or liability, a reporting entity shall evaluate the significance and relevance
of factors such as the following:
• There are few recent transactions.
• Price quotations are not developed using current information.
• Price quotations vary substantially either over time or among market makers
(e.g., some brokered markets).
•
Indices that previously were highly correlated with the fair values of the asset
or liability are demonstrably uncorrelated with recent indications of fair value
for that asset or liability.
• There is a significant increase in implied liquidity risk premiums, yields, or
performance indicators (such as delinquency rates or loss severities) for
observed transactions or quoted prices when compared with the reporting
entity’s estimate of expected cash flows, taking into account all available
market data about credit and other nonperformance risk for the asset or
liability.
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16. Overview of ASC Subtopic 820-10
• There is a wide bid-ask spread or significant increases in the bid-ask spread.
• There is a significant decline in the activity of, or there is an absence of, a
market for new issues (that is, a primary market) for the asset or liability or
similar assets or liabilities.
• Little information is publicly available (e.g., for transactions that take place in
a principal-to-principal market).
16.073 ASC paragraph 820-10-35-54G confirms that the objective of a fair value
measurement remains the same even if the volume and level of activity in the market for
the asset or liability have significantly decreased, regardless of the valuation technique or
techniques used. Fair value is the price that would be received to sell the asset or transfer
the liability in an orderly transaction (that is, not a forced liquidation or distress sale)
between market participants at the measurement date under current market conditions.
16.074 If an entity concludes that there has been a significant decrease in the volume or
level of activity for the asset or liability in relation to normal market activity for the asset
or liability (or for similar assets or liabilities), further analysis of the transactions or
quoted prices is needed. A decrease in the volume or level of activity on its own may not
indicate that a transaction price or quoted price does not represent fair value or that a
transaction in that market is not orderly. However, if a reporting entity determines that a
transaction or quoted price does not represent fair value (e.g., there may be transactions
that are not orderly), an adjustment to the transactions or quoted prices will be necessary
if the reporting entity uses those prices as a basis for measuring fair value and that
adjustment may be significant to the fair value measurement in its entirety. Adjustments
also may be necessary in other circumstances (e.g., when a price for a similar asset
requires significant adjustment to make it comparable to the asset being measured or
when the price is stale). ASC paragraph 820-10-35-54D
16.075 ASC Subtopic 820-10 does not prescribe how to make significant adjustments to
transactions or quoted prices. Regardless of the valuation technique used, a reporting
entity would include appropriate risk adjustments, including a risk premium reflecting the
amount that market participants would demand as compensation for the uncertainty
inherent in the cash flows of an asset or a liability. If there has been a significant decrease
in the volume or level of activity for the asset or liability, a change in valuation technique
or the use of multiple valuation techniques may be appropriate.
Identifying Transactions That Are Not Orderly
16.076 Entities should consider whether information indicates that an observed
transaction was not orderly. Entities may not assume that all transactions are not orderly
even if there has been a significant decrease in the volume and level of activity for the
asset or liability. A transaction price that is associated with a transaction that is not
orderly is not determinative of fair value or market-participant risk premiums. Entities
should use judgment to determine whether evidence indicates that a transaction is not
orderly. Although not necessarily determinative, entities should consider factors such as:
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16. Overview of ASC Subtopic 820-10
• Exposure to the market for a period before the measurement date was not
adequate to allow usual and customary marketing activities for transactions
involving the asset or liability under current market conditions.
• There was a usual-and-customary marketing period, but the seller marketed
the asset or liability to a single market participant.
• The seller is in or near bankruptcy or receivership (a distressed transaction).
• The seller was required to sell to meet regulatory or legal requirements (the
seller was forced).
• The transaction price is an outlier when compared to other recent transactions
for the same or a similar asset or liability.
16.077 Reporting entities should consider all of the following when measuring fair value
or estimating market risk premiums:
• Entities should place little, if any, weight (compared with other indications of
fair value) on transactions that are not orderly when estimating fair value or
market risk premiums.
• Entities should consider the transaction price of orderly transactions when
estimating fair value or market risk premiums. The amount of weight placed
on that transaction price (compared to the weight placed on other indications
of fair value) depends on specific facts, such as the volume of the transaction,
the comparability of the transaction to the asset or liability being measured at
fair value, and the proximity of the transaction to the measurement date.
•
If a reporting entity does not have sufficient information to conclude whether
a transaction is orderly, it would take into account the transaction price
However, that transaction price may not represent fair value (that is, the
transaction price is not necessarily the sole or primary basis for measuring fair
value or estimating market risk premiums). When a reporting entity does not
have sufficient information to conclude whether particular transactions are
orderly, the reporting entity would place less weight on those transactions
when compared with other transactions that are known to be orderly.
16.078 Entities need not undertake exhaustive efforts to determine whether a transaction
is orderly, but should not ignore information that is reasonably available. When a
reporting entity is a party to a transaction, it is presumed to have sufficient information to
conclude whether the transaction is orderly.
16.079 ASC paragraph 820-10-35-54K notes that ASC Subtopic 820-10 does not
preclude the use of quoted prices provided by third parties, such as pricing services or
brokers, if a reporting entity has determined that the quoted prices provided by those
parties are developed in accordance with ASC Subtopic 820-10. However, entities should
carefully evaluate those quoted prices to determine whether they are based on current
information that reflects orderly transactions or a valuation technique that reflects market
participant assumptions (including assumptions about risk). Entities should place less
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weight on quotes that do not reflect the result of transactions. Entities should place more
weight on quotes based on binding offers than on quotes based on indicative prices.
16. Overview of ASC Subtopic 820-10
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Section 17 - Determining the Fair Value of
Assets Acquired and Liabilities Assumed
in a Business Combination
Detailed Contents
Overview
FASB Valuation Resource Group
Use of a Third-Party Valuation Professional
Illustrative Balance Sheet
Assets
Overview
Cash and Cash Equivalents
Trade and Other Receivables
Example 17.1: Determination of Fair Value of Acquired Trade Receivables
Inventories
Raw Materials and Supplies
Finished Goods and Work-in-Process
Q&A 17.1: Acquisition of a Business That Outsources the Manufacturing Process
and Has Patent Protection
Q&A 17.2: Measurement of the Fair Value of Inventories That Will Be
Discontinued
Example 17.2: LIFO Method
Debt and Equity Securities
Debt and Equity Securities-Classification
Debt and Equity Securities-Measurement
Example 17.3: Restriction on Sale of Security
Other Securities
Equity Method Investments
Property, Plant, and Equipment
Example 17.4: Apportionment of Unit of Measurement to the Individual Units of
Account
Example 17.4a: Valuation of Assets That Are Subject to a Government Grant
Sales Comparison Method
Income Capitalization Method
(Pre-ASC Topic 842*) Replacement Cost New Method
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17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
Property, Plant, and Equipment to Be Used
Property, Plant, and Equipment to Be Sold (Held for Sale)
Mining Assets
Intangible Assets
Valuation Analysis
Market Approach
Income Approaches
Cost Approach
Intangible Assets Commonly Acquired in Business Combinations
Long-Term Construction-Type Contracts (Pre-ASC Topic 606)
Accounting under the Completed Contract Method#
Example 17.5: Accounting for LTCC (Completed Contract Method)
Accounting under the Percentage of Completion Method#
Example 17.6: Accounting for LTCC (Percentage of Completion Method)
Contracts with Customers (after Adoption of ASC Topic 606##)
Contract Assets (after Adoption of ASC Topic 606##)
Contract Liabilities (after Adoption of ASC Topic 606)
Accounting for Acquired Revenue Contracts (after Adoption of ASC Topic
606)##
Example 17.6a: Accounting for an Acquiree's Revenue Contract after Adopting
ASC Topic 606
(Pre-ASC Topic 842*) Operating and Capital Leases
Operating Leases
Capital Leases
(ASC Topic 842) Leases (Acquiree Is Lessee)
(ASC Topic 842) Leases (Acquiree Is Lessor)
(Before and after Adopting ASC Topic 842*) Income Producing Real Estate in the
Real Estate Industry
Q&A 17.3: Purchase of a Real Estate Development Company
Liabilities
Overview
Trade Accounts and Notes Payable
Deferred Revenue (Pre-ASC Topic 606##)
Market Approach
Income Approach
Example 17.7: Deferred Revenue
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17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
(Pre-ASC Topic 842*) Deferred Revenue Arising from a Vendor-Financed
Leasing Arrangement
Long-Term Debt
Market Approach
Income Approach
Example 17.8: Determining the Fair Value of Debt Assumed in a Business
Combination
Asset Retirement Obligation
Derivative Instruments
Redeemable Preferred Stock
Example 17.9: Redeemable Preferred Stock Held by Noncontrolling Interests
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17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
OVERVIEW
17.000 As stated in Section 7, Recognizing and Measuring the Identifiable Assets
Acquired, the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree, ASC
Topic 805, Business Combinations, requires an acquirer to recognize, separately from
goodwill, the identifiable assets acquired, liabilities assumed, and any noncontrolling
interests in the acquiree, and to measure such items at their acquisition date fair values in
accordance with ASC Subtopic 820-10, Fair Value Measurement - Overall, with certain
exceptions. This Section provides general guidance on the measurement of certain assets
acquired and liabilities assumed in a business combination. A modified balance sheet has
been provided to demonstrate commonly used valuation approaches to measure the
acquisition-date fair value of those assets and liabilities.
17.001 The guidance herein is based on general valuation principles, and the specific
approach may differ for a specific transaction depending on the facts and circumstances,
including the relevant market participant assumptions and available information at the
measurement date. Fair value measurements require the application of judgment and for
some items the use of complex valuation techniques to determine fair value.
FASB VALUATION RESOURCE GROUP
17.002 In June 2007, the FASB formed a FASB Valuation Resource Group (the VRG) to
address issues related to valuation for financial reporting consistent with their mission to
improve and enhance the quality, consistency, and comparability of financial reporting.
The FASB continues to assess whether and to what extent additional and more specific
valuation guidance is needed for financial reporting purposes beyond the guidance
provided in ASC Subtopic 820-10. As part of this process, the VRG meets periodically to
provide the FASB staff with information on existing implementation issues surrounding
fair value measurements used for financial reporting purposes and alternative viewpoints
associated with those implementation issues. However, the VRG does not make
authoritative decisions and ultimately all authoritative decisions are subject to the
FASB’s normal open due process, including public deliberation by the FASB.
USE OF A THIRD-PARTY VALUATION PROFESSIONAL
17.003 The application of ASC Topic 805 requires fair value measurements for assets
acquired and liabilities assumed and noncontrolling interests in a business combination.
While ASC Topic 805 does not require an entity to use a third-party valuation
professional to determine fair value for such items, an entity should consider whether it
employs competent and knowledgeable professionals to perform those measurements. In
many situations, an entity may have in-house expertise for valuing some, but not all, of
the assets acquired and liabilities assumed. Therefore, the need to use a third-party
valuation professional is expected to vary by entity and even by transaction.
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17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
ILLUSTRATIVE BALANCE SHEET
17.004 The table below provides items commonly found on balance sheets that would be
subject to fair value measurement in applying the acquisition method. The table provides
the valuation approach (market, income, or cost) commonly used for these items;
however, in specific situations, depending on the information available, other approaches
may be appropriate.
Common Fair Value Measurement Approaches
Assets
Current assets:
Cash and cash equivalents
Trade and other receivables
Inventories
Finished goods
Work-in-process
Raw materials
Long-term assets:
Debt and equity securities
Plant and equipment
Intangible assets
Long-term construction-type contracts
Operating and capital leases (Pre-ASC
Topic 842*)
Income producing real estate (Pre-ASC
Topic 842*)
Liabilities
Current liabilities:
Trade accounts payable
Deferred revenue
Notes payable
Long-term liabilities:
Long-term debt
Asset retirement obligation
Derivative instruments
Contingent consideration
Deferred income taxes (a)
Liability for pension benefits (a)
Redeemable preferred stock
Valuation Approaches
Market
Income
Cost
F
S
F
F
F
S
F
F
F
S
N/A
N/A
S
S
F
F
N/A
See Plant and Equipment Section
See Intangible Assets Section
S
O
S
F
F
O
F
F
S
F
S
N/A
N/A
F
F
F
F
F
F
F
F
F
F
F
N/A
N/A
F
S
F
F
N/A
S
N/A
N/A
S
N/A
S
N/A
N/A
S
(a) Exceptions to the recognition and measurement principles. See Section 7 for further
discussion.
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17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
Labeling Key
F = Applied Frequently
O = Applied Occasionally
S = Applied Seldom
ASSETS
OVERVIEW
17.005 Concepts Statement 6 defines assets as “probable future economic benefits
obtained or controlled by a particular entity as a result of past transactions or events.”
With limited exceptions, ASC Topic 805 requires that assets acquired and liabilities
assumed in a business combination be measured at fair value determined in accordance
with ASC Subtopic 820-10, including the requirement to consider the highest and best
use for the unit of measure, regardless of the acquirer’s intended use.
17.006 The following section identifies valuation techniques commonly used to measure
the acquisition date fair value of assets acquired and liabilities assumed in a business
combination.
CASH AND CASH EQUIVALENTS
17.007 Cash equivalents are highly liquid investments that are readily convertible to
known amounts of cash and generally have a maturity of three months or less when
purchased. Given the short-term nature and “insignificant risk of changes in value
because of changes in interest rates,” according to ASC Section 230-10-20, the carrying
amount or nominal amount is often assumed to approximate fair value for cash and cash
equivalents. However, the acquiring entity should make its own evaluation of the
instruments classified by the acquiree as cash and cash equivalents to determine whether
an assumption of insignificant risk of changes in value in response to interest rate
changes is supportable, as that conclusion generally is the basis for using carrying amount
or nominal amount as the approximation of fair value for such instruments.
TRADE AND OTHER RECEIVABLES
17.007a Measuring trade and other receivables acquired in a business combination is
affected by ASU 2016-13, Measurement of Credit Losses on Financial Instruments,
which established ASC Topic 326, Financial Instruments--Credit Losses. The table
below sets out the mandatory adoption dates for ASC Topic 326, as amended by ASU
2019-10, Effective Dates.
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17. Determining the Fair Value of Assets Acquired
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Annual and interim periods beginning
after…
Public business entities that are SEC
filers, excluding entities eligible to be
smaller reporting companies as defined by
the SEC
December 15, 2019
All other entities
December 15, 2022
17.007b See chapter 25 of KPMG Handbook, Credit impairment, for detailed information
about the effective date, early adoption, and transition requirements of ASC Topic 326.
See section 12.3 of that Handbook for guidance on measuring financial assets acquired in
a business combination after adopting ASC Topic 326. The remainder of this section
addresses measuring acquired trade and other receivables before adopting ASC Topic
326.
17.008 Receivables acquired in a business combination should be measured at fair value
without a related allowance account. The objective of fair value measurement of
receivables is to approximate the amount that would be received if the receivables were
sold in a transaction with market participants (an exit price) under current market
conditions. For some trade receivables, this amount may be approximated by the amount
that would be received from factoring the receivables. Alternatively, the fair value of
receivables could be measured at the present value of the contractually required payments
discounted using an interest rate reflecting market participants’ requirements at the
measurement date. Because ASC Topic 805 does not permit the recognition of a separate
valuation allowance for receivables acquired in a business combination, the effects of
timing and uncertainty about future cash flows (i.e., credit and liquidity risk) are included
in the measurement of fair value of those receivables.
17.009 The interest rate used in the measurement should be commensurate with the risk
associated with uncertainty about future cash flows reflecting the expectations of market
participants. Paragraphs 13 and 14 of APB Opinion No. 21, Interest on Receivables and
Payables (ASC paragraphs 835-30-25-12 and 25-13), provide guidance in arriving at an
appropriate interest rate.
17.010 In September 2008, the VRG noted that in practice some entities recognize
components of working capital, including trade accounts receivable, at the acquiree’s
book value, because the differences resulting from current interest rates are often deemed
to be insignificant. However, use of this approach is a non-GAAP policy and,
accordingly, entities should evaluate the potential significance of the policy and be able
to support that applying the non-GAAP policy is immaterial to the entity’s financial
statements at the date of acquisition and in subsequent periods.
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17. Determining the Fair Value of Assets Acquired
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Example 17.1: Determination of Fair Value of Acquired Trade Receivables
ABC Corp. acquires DEF Corp. in a business combination. At the acquisition date, ABC
determines the fair value of the trade receivable of DEF, as follows:
Commercial
Acquired Trade Receivables
Other
Consumer
Contractually required
payments receivable at
acquisition date
Cash flows expected
to be collected
Difference
Estimated fair value
Difference
$
$
1,200
1,115
575
495
225
210
1,103
489
208
Total
(a)
2,000 (b)
1,820 (c)
(180) (d)
1,800 (e)
(20) (f)
(a) Disaggregated as commercial, consumer, and other trade receivables based on
pool of receivables with common attributes and risk characteristics.
(b) Book value of DEF’s contractually required payments receivable at date of
acquisition.
(c) Estimated future cash flows expected to be collected, considering uncertainty
about future cash flows (i.e., estimated credit risk).
(d) Difference relates to total estimated credit risk of trade receivables.
(e) Present value of estimated future cash flows using an appropriate interest rate,
considering estimated timing associated with the cash flows.
(f) Difference between DEF’s carrying amount and estimated fair value.
17.011 Because the fair value of a tax-exempt note receivable may be affected by
conditions other than changes in interest rates, such as changes in tax laws, determining
the fair value of a tax-exempt note acquired in a business combination by adjusting the
previous carrying amount for the effects of the difference between current interest rates
and the stated rate on the note may not be sufficient. It may be necessary to obtain
independent appraisals from an investment adviser or broker in determining the fair value
of tax-exempt notes.
INVENTORIES
17.011a The AICPA has convened a task force to develop an Accounting and Valuation
Guide — Business Combinations (the AICPA Business Combinations Guide), which will
provide guidance and illustrations for preparers, independent auditors, and valuation
specialists regarding the accounting and valuation considerations for business
combination transactions. The guidance below reflects the latest framework, but may
require updating once the guidance contained in the AICPA Business Combinations
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17. Determining the Fair Value of Assets Acquired
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Guide is finalized. At the current time, KPMG recommends consulting a valuation
professional for additional guidance on the topic.
17.012 FASB Statement No. 141 (Statement 141), Business Combinations, provided
more guidance than ASC Topic 805 regarding measurement methods for specific assets
and liabilities assumed in business combinations, including inventory. While the
guidance for valuing inventory in paragraph 37 of Statement 141 has been superseded, it
was aligned with the tax guidance for estimating fair market value of inventory specified
in IRS Revenue Procedure 2003-51. In practice, methods used for valuing inventory
remain consistent with the superseded Statement 141 and Revenue Procedure 2003-51
guidance.
17.013 Conceptually, the analysis of inventory can be thought of as an allocation of value
created pre-valuation date by the seller versus post-valuation date by the buyer. The fair
value of inventory is estimated as the value created prior to the acquisition date—this
represents the process of procuring and manufacturing the inventory. The fair value
measurement should provide the seller with fair compensation for the efforts and costs
previously incurred and assets used related to the inventory, while allowing the market
participant buyer to be fairly compensated for its purchase, risk, future efforts, and assets
used to complete and dispose of the inventory after the acquisition date.
17.014 The valuation method used to measure the fair value of inventory acquired in a
business combination depends on its stage in the production cycle (finished goods, work-
in-process (WIP), or raw materials) on the acquisition date and availability of reliable
inputs. Historically, finished goods and WIP inventory have typically been valued using
the Comparative Sales Method (Top-down Method) and raw materials were typically
valued using the Replacement Cost Method (Bottom-up Method). Theoretically, applying
a Top-down or Bottom-up Method should result in a consistent measure of the inventory
value.
Raw Materials and Supplies
17.015 The fair value of raw materials, including supplies and spare parts, would be the
price a market participant could achieve in a current sale. Raw materials inventory is
often valued using the Bottom-up Method because typically there are fewer subjective
assumptions. If no preparation costs have been incurred, the Bottom-up Method may
simply be an analysis of the net book value as of the valuation date. However,
adjustments to book value would need to be considered. Supplies purchased to be
consumed directly or indirectly in production are measured at fair value, often in the
same manner as raw materials.
17.016 If applicable, the target's book value of raw materials prior to the acquisition may
be reduced to account for obsolete, defective, and subnormal goods as well as shrinkage,
and adjusted to account for variances between actual and standard costs. Shrinkage refers
to differences between accounting and actual inventory quantities (e.g., due to theft,
damage, miscounting, incorrect units of measure, evaporation). Variances refers to
difference between the actual and standard costs, applicable if standard cost is used (e.g.,
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17. Determining the Fair Value of Assets Acquired
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by manufacturing companies). These reserves and variances should be considered in the
starting point when using a Bottom-up Method. However, LIFO is not an appropriate
starting point for estimating the fair value of raw materials because it does not represent
current replacement cost. If the inventory cost accounting is based on LIFO, the starting
point for the valuation should be the gross amount, before consideration of the LIFO
reserve.1 Fair value of raw materials may approximate book value as of the valuation date
if the following exists: FIFO accounting is used, inventory is measured at actual cost, any
preparation costs are minimal, and the reserves fully account for obsolete and defective
goods as well as shrinkage.
Finished Goods and Work-in-Process
17.017 In the Top-down Method, the value of finished goods and WIP inventory is based
on the estimated selling price less the sum of (a) costs of disposal2, (b) [any] costs to
complete WIP, and (c) a reasonable profit allowance for the efforts contributed and assets
used by the buyer (acquirer). Amounts not deducted when using the Top-down Method
would have implicitly been added to the book value if valuing inventory using the
Bottom-up Method. Thus, in the Bottom-up Method, the value is based on (a) the book
value, including costs already incurred toward procurement and manufacturing efforts,
and (b) a reasonable profit allowance for the efforts contributed and assets used by the
acquiree.
17.018 Similar to raw materials, the book value of finished goods and WIP, after
consideration of reserves for obsolescence, defective goods, and shrinkage, as well as
variances, may serve as a starting point for the Bottom-up Method. However, the starting
point should exclude the LIFO reserve, because LIFO does not represent current
replacement cost.
17.019 For the valuation of finished goods and WIP inventory, it is relevant to first
identify the appropriate baseline projected financial information (PFI). Conceptually, this
should represent the market participant PFI for the period consistent with the lifecycle of
the subject inventory (i.e., from procurement to sale). The acquiree's PFI may be a good
starting point, but adjustments may be needed to reflect a market participant perspective.
The baseline PFI should represent the income statement through EBITA, and provide
detail on the breakdown of expenses (e.g., R&D, marketing, depreciation, etc.). If
projected financial data is not sufficiently detailed, then historical financial statements
may be used as a proxy but adjustments may be necessary to be consistent with the
lifecycle of the subject inventory (e.g., adjustments for seasonality, etc.).
17.020 The Top-down Method begins with an assessment of the selling price of the
inventory to the company’s direct customer in the principal or most advantageous market.
The selling price should be consistent with the selected baseline PFI used throughout the
inventory valuation analysis. Selling prices can be derived directly from observed or
listed selling prices on a per unit basis or indirectly through a gross margin analysis, as
appropriate. A gross margin analysis estimates the selling price of the inventory by
dividing the adjusted net book value of finished goods by the appropriate gross profit
margin percentage.
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17. Determining the Fair Value of Assets Acquired
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17.020a The analysis of costs of disposal for the Top-down Method and costs already
completed for the Bottom-up Method is based on the selected baseline PFI. The first step
is to exclude any costs that are intended to benefit future periods, such as R&D costs
related to new product development, marketing costs for a new product, training costs to
increase the size of the workforce, costs for expansion into a new territory, depreciation
of an R&D facility dedicated to future research, or restructuring costs. Removing the
future-benefit direct and indirect costs generally results in an adjusted baseline PFI with
higher margins. The next step is to identify the proportion of the costs in the adjusted
baseline PFI that already have been incurred with respect to the finished goods inventory
versus the proportion of costs that will be incurred during the disposal process of finished
goods inventory. Costs of disposal would include both direct selling and marketing costs
as well as a portion of the indirect overhead costs such as general and administrative
expenses and depreciation. Similarly costs incurred would include costs of procuring raw
materials and manufacturing as well as a portion of the indirect overhead costs such as
general and administrative costs and depreciation.
17.020b The WIP analysis of costs to complete (for the Top-down Method) and
manufacturing costs already completed (for the Bottom-up Method) is performed on the
subset of the adjusted baseline PFI assumed to have been contributed to finished goods in
the functional apportionment above. These costs can be further bifurcated into the
completed portion that relates to the effort of procuring raw materials and manufacturing
WIP already incurred pre-measurement date versus those costs that relate to the
remaining incremental effort to bring the WIP to its finished state. The completion costs
should be only those that are incremental to the disposal costs that have already been
estimated for the inventory once finished.
17.020c The reasonable profit allowance may also be derived from the adjusted baseline
PFI. Based on the assumptions above, the acquirer determines a profit margin earned pre-
and post-measurement date on the cost structure. However, the acquirer may need to
adjust those amounts based on the relative efforts exerted, risks assumed, value added,
and assets used with respect to the inventory. In some cases the value added or intangible
assets used during the procurement and manufacturing of the inventory pre-valuation date
may not be the same as those contributed post-valuation date. For example, the materials
portion of cost of goods sold may not contribute any value added benefit and may not
drive the profit earned.
17.020c1 When internally developed intangible assets contribute to the level of
profitability for the business, to determine the reasonable profit allowance the acquirer
should evaluate whether each of those intangible assets has been used during the
procurement and manufacturing of the finished goods and WIP inventory or remain to be
used during the disposition process. If the intangible asset is used as part of the
manufacturing process, the profit allowance for the manufacturing is increased by the
profit contribution of the internally developed intangible assets. If it used as part of the
disposal process, the profit contribution of the internally developed intangible assets is
considered in the profit allowance of the disposal process. Alternatively, rather than
adjusting the profit allowance, one can take into account the internally developed
intangible asset by considering a hypothetical implied royalty rate as an additional cost
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17. Determining the Fair Value of Assets Acquired
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element of either the manufacturing process or the disposal process. Under either
approach the profit contribution of the intangible asset is assigned to where the intangible
asset is used (either manufacturing or disposal), similar to the process described in
Paragraph 17.020a.
17.020d Holding costs may be estimated to account for the opportunity cost associated
with the time required to sell the inventory (time to sale). This represents the foregone
return on investment during the time to sell the inventory. Holding costs are based on the
inventory turnover rate and the cost of borrowing. Time to sale may be estimated by
analyzing historical inventory turnover rates. The rate of return (borrowing cost)
applicable to the inventory is generally lower than the overall rate of the business and
may approximate the return on working capital. Diversity in practice exists with respect
to including holding costs and, even when included, there is diversity in practice with
respect to how to calculate them. Holding costs may be immaterial if the inventory
turnover is high or the borrowing rate is low.
Q&A 17.1: Acquisition of a Business That Outsources the Manufacturing
Process and Has Patent Protection
Q. Should an entity that acquires a business that outsources the manufacture of its
proprietary widgets and enjoys a high gross margin and low selling cost owing to patent
protection, record acquired inventory at the historic cost to the acquiree?
A. No. ASC Topic 805 requires that an entity measure identifiable acquired assets at their
acquisition-date fair values using a market participant perspective. In the Top-down
Method, the fair value of finished goods inventories is measured from the perspective of
a market participant as the selling price less the sum of (a) costs of disposal and (b) a
reasonable profit allowance for the selling effort of the acquirer (selling margin). In this
example, the high gross margin realized by the acquiree is inherent in the historical cost
of the widget to the acquirer. Because the high gross margin relates to patent protection
and the patent is used as part of the manufacturing process, it is contributed to the
inventory as part of the manufacturing process and therefore increases the fair value of
inventory. The fact that the entity outsources the production to a third party is irrelevant
as the third-party contract manufacturer uses the know-how of the patent in the
production process.
The acquirer recognizes an intangible asset associated with the patent protection that
historically allowed the acquiree to realize the high margins (i.e., the patent was
internally generated and not recognized as an asset in the acquiree’s financial statements).
The fair value of the intangible asset would be adjusted to reflect the portion that has
been contributed to inventory and therefore already included in the fair value of the
inventory.
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17. Determining the Fair Value of Assets Acquired
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Q&A 17.2: Measurement of the Fair Value of Inventories That Will Be
Discontinued
ABC Corp. operates retail hardware stores. ABC acquires DEF Corp., also a hardware
retailer. In the transaction, ABC acquires inventories of DEF, including certain products
that DEF has historically stocked and sold under brand names not sold in ABC stores.
Some of the inventories on hand for the DEF products are liquidated as ABC does not
intend to continue selling the DEF-branded products. DEF stores will mark down and sell
the existing inventory and then will begin to sell ABC’s products and brands.
Q. How should inventories of DEF’s products that will be discontinued after the
acquisition be valued in the acquisition accounting?
A. The fair value of the inventories acquired should be based on the expected selling
price of the units from a market participant perspective. If a market participant is
expected to continue to sell the DEF-branded products, then the baseline PFI should
reflect this. If, however, a market participant is expected to liquidate the DEF-branded
products, the baseline PFI should reflect liquidation prices and cost structure.
In general, if a market participant retailer is expected to continue selling the acquired
inventory, the fair value of that inventory for a retailer is often similar to its book value.
This is because the profit on the selling effort left to be earned post-acquisition is often a
large percentage of the overall profit. For retailers, most of the inventory is purchased for
resale (i.e., cost of goods sold is not a value-added expense) and the inventory tends to
turn quickly.
Example 17.2: LIFO Method
ABC Corp. acquired DEF Corp. on January 1, 20X0. Before the acquisition, DEF
measured its inventory using the LIFO method. ABC’s similar inventory is also measured
using the LIFO method. The carrying amount of DEF’s inventory under the LIFO method
as of January 1, 20X0, and the fair value of the inventory at the date of acquisition is as
follows:
20X7 – Base year
20X8 – Layer
20X9 – Layer
Total inventory
LIFO
Fair Value
$
$
100
50
75
225
$
305
Under ASC paragraph 330-10-S99-1 (which supports conclusions reached in AICPA
Issues Paper, Identification and Discussion of Certain Financial Accounting and
Reporting Issues Concerning LIFO Inventories), ABC should measure the acquisition-
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17. Determining the Fair Value of Assets Acquired
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date fair value of the acquired inventory at $305. If the acquired inventory is deemed to
be a separate LIFO pool, this amount becomes the base year layer for the inventory to
apply LIFO in periods subsequent to the acquisition. If it is deemed to be part of the
existing LIFO pool (i.e., it is similar to ABC’s existing inventory), then this amount is
included in the current period’s purchases to determine the current period LIFO layer.
DEBT AND EQUITY SECURITIES
17.021 Debt and equity securities include investments in U.S. Treasury securities,
corporate debt securities, and equity securities publicly traded on an active exchange
(e.g., the New York Stock Exchange).
DEBT AND EQUITY SECURITIES-CLASSIFICATION
17.022a Debt securities should be classified as held-to-maturity, available-for-sale or
trading securities, under ASC Topic 320, Investments--Debt Securities, based on the
intent and ability of the acquirer rather than the historical classification of the securities
by the acquiree. ASC Topic 805 requires that the acquirer make those classifications or
designations based on contractual terms, economic conditions, the acquirer’s operating or
accounting policies, and other relevant conditions existing at the acquisition date. All
investments in equity securities (other than those to which consolidation or equity method
accounting applies) are accounted for under ASC Topic 321, Investments--Equity
Securities. Generally, equity securities are initially and subsequently measured at fair
value, with changes in fair value reported currently in earnings. However, an entity can
elect an accounting policy to measure equity securities without readily determinable fair
value at cost minus impairment, if any, plus or minus changes resulting from observable
price changes. See KPMG publication, Financial instruments--Recognition and
measurement of financial assets and financial liabilities, for additional guidance. ASC
paragraph 805-20-25-6
DEBT AND EQUITY SECURITIES-MEASUREMENT
17.023 Regardless of classification, securities acquired in a business combination are
measured at fair value at the date of acquisition. Quoted market prices (Level 1 inputs), if
available, generally provide the most reliable and best evidence of fair value. In certain
circumstances, quoted market prices may need to be adjusted downward to recognize the
possible effects of security-specific restrictions because other market participants would
consider the restrictions when measuring the fair value of the securities. In those
circumstances, ASC Subtopic 820-10 requires the fair value of a restricted security be
measured based on a quoted price of an otherwise unrestricted security of the same issuer
adjusted for the effect of the restriction.
17.024 Consistent with ASC Subtopic 820-10, quoted market prices should only be
adjusted for restrictions that are specific to the security and, therefore, would transfer to
market participants. For security-specific restrictions, the price used in the measurement
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17. Determining the Fair Value of Assets Acquired
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of fair value should include an adjustment for the effect of the restriction. Conversely, for
entity-specific restrictions, the price used in the measurement of fair value of the
securities would not be adjusted to reflect the restriction. Determining whether a
restriction is entity-specific or security-specific may require judgment based on the
specific facts and circumstances.
17.025 In the absence of an available quoted market price for securities, fair value is
often determined using a market approach or income approach, fair value measurements
that use Level 2 or Level 3 inputs. See section H in KPMG Fair Value Measurements -
Questions and Answers for additional discussion.
Example 17.3: Restriction on Sale of Security
The reporting entity holds a security of an issuer for which sale is legally restricted for a
specified period. The restriction is determined to be specific to (an attribute of) the
security and, therefore, would transfer to market participants.
The fair value of the security is based on the quoted price for an otherwise identical
unrestricted security of the same issuer that trades in a public market, adjusted to reflect
the effect of the restriction. The adjustment reflects the amount market participants would
demand because of the risk relating to the inability to access a public market for the
security for the specified period.
The adjustment depends on the nature and duration of the restriction, the extent to which
buyers are limited by the restriction (e.g., a large number of qualifying investors), and
factors specific to both the security and the issuer (qualitative and quantitative).
ASC paragraph 820-10-55-52
17.026 If the reporting entity manages a group of financial assets or financial liabilities
on the basis of its net exposure to either market risk or credit risk, the reporting entity is
permitted to measure the fair value of the group of financial assets or financial liabilities
on the basis of the price that would be received to sell a net long position or to transfer a
net short position. The reporting entity should measure the fair value of the group
consistent with how market participants would price the net risk exposure. The exception
does not pertain to financial statement presentation. As such, the reporting entity may
need to allocate portfolio-level adjustments to the individual assets or liabilities that make
up the group of financial assets and financial liabilities managed on the basis of the
reporting entity’s net risk exposure.
OTHER SECURITIES
17.027 Determining the fair value of securities that are not quoted in active markets may
require the use of valuation techniques. ASC Subtopic 820-10 states that in some
instances more than one of the three valuation approaches discussed (market approach,
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17. Determining the Fair Value of Assets Acquired
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income approach, and cost approach or their underlying techniques) may be required to
develop the measurement of fair value.
17.028 In these instances, entities should consider, among other things, the reliability of
the valuation approaches and underlying techniques and the inputs used in the techniques.
If a particular market-based approach relies on higher level inputs (e.g., observable
market prices) compared to a particular income-based approach that relies heavily on
projections of income, the reporting entity should apply greater weight to the
measurement of fair value generated by the market-based approach, because it relies on
higher-level inputs.
17.029 ASC Subtopic 820-10 notes that any, or a combination, of the techniques should
be used to measure fair value if the techniques are appropriate in the circumstances.
However, when multiple valuation techniques are used to measure fair value, ASC
Subtopic 820-10 does not prescribe a mathematical weighting scheme, but requires the
use of judgment. Valuation professionals, in many instances, consider multiple valuation
approaches and underlying techniques but may conclude that a single valuation technique
is appropriate to determine fair value. In instances when multiple valuation techniques
are relied on to measure fair value, the techniques should be evaluated for reasonableness
and reliability, and the valuation professional should determine if and how the techniques
should be weighted. In some cases, a secondary technique is used only to corroborate the
reasonableness of the most appropriate technique.
EQUITY METHOD INVESTMENTS
17.029a Equity method investments, like equity securities or other securities, are
measured at fair value at the date of acquisition. In accordance with ASC Topic 323, an
acquirer is also required to prepare a memo purchase price allocation at the date of
acquisition to allocate the fair value of the investment to the net assets of the equity
method investee. See Section 3.3 of KPMG Handbook, Equity method of accounting, for
a further discussion of the memo purchase price allocation.
PROPERTY, PLANT, AND EQUIPMENT
17.030 Property, plant, and equipment includes land, buildings, machinery and
equipment, leasehold improvements, buildings and leasehold improvement construction-
in-progress, and other related tangible assets. ASC Subtopic 820-10 requires that an
entity determine the highest and best use of a nonfinancial asset. An entity determines the
premise of use whereby market participants would maximize value. The highest and best
use of an asset could be on a stand-alone basis or in combination with other assets and
liabilities as a group. It should be noted that property, plant, and equipment that qualifies
as held-for-sale is measured at fair value less cost to sell at the acquisition date in
accordance with ASC Section 360-10-35. Because of the cost to sell element, the
measurement of property, plant, and equipment that is classified as held-for-sale is an
exception to the fair value measurement principle in ASC Topic 805.
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17. Determining the Fair Value of Assets Acquired
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17.031 Rate regulated entities generate required revenue based on allowable costs,
including the costs incurred to acquire, construct, or develop the assets, and a reasonable
return. This economic model is called a cost of service model. These rate-regulated
entities are subject to accounting and reporting requirements based on the guidance
provided in ASC Topic 980, Regulated Operations. For rate-regulated entities that are
subject to ASC Topic 980, the carrying amount of property, plant, and equipment is
assumed to be fair value because it is expected that the assets will generate required
revenue that approximates the allowable costs and returns approved by the regulatory
authorities. However, such an approach to determining the fair value of a cost-based rate
regulated asset may not be appropriate if it is expected that the rate-regulated entity will
no longer be regulated, regulatory authorities are expected to change the allowable costs,
or other types of rate action are expected to be imposed by regulatory authorities.
17.032 The fair value can be estimated using a market approach (e.g., sales comparison
method, see Paragraph 17.041), an income approach (e.g., income capitalization method,
see Paragraph 17.042), or a cost approach (e.g., replacement cost new method, see
Paragraph 17.043), or a combination of multiple approaches, depending on facts and
circumstances.
17.033 Factors to consider when evaluating the appropriate valuation technique include:
(a) the type of asset being measured; (b) identifying the principal (or most advantageous)
market and market participants for the assets acquired; and (c) the appropriate valuation
premise (stand-alone or in combination with other assets or assets and liabilities as a
group), consistent with the acquired assets’ highest and best use.
17.034 ASC Subtopic 820-10 includes the concept of highest and best use for a
nonfinancial asset to determine the appropriate valuation premise to measure fair value
for a single nonfinancial asset or group of nonfinancial assets. ASC Subtopic 820-10
identifies two premises of value: in combination with other assets or assets and liabilities
as a group and stand-alone. For nonfinancial assets, either premise may produce the
highest and best use. The premise selected provides maximum value to market
participants.
ASC Paragraph 820-10-35-10A
A fair value measurement of a nonfinancial asset takes into account a market
participant’s ability to generate economic benefits by using the asset in its highest
and best use or by selling it to another market participant that would use the asset
in its highest and best use.
ASC Paragraph 820-10-35-10B
The highest and best use of a nonfinancial asset takes into account the use of the
asset that is physically possible, legally permissible, and financially feasible as
follows:
a. A use that is physically possible takes into account the physical
characteristics of the asset that market participants would take into account
when pricing the asset (for example, the location or size of a property).
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b. A use that is legally permissible takes into account any legal restrictions on
the use of the asset that market participants would take into account when
pricing the asset (for example, the zoning regulations applicable to a
property).
c. A use that is financially feasible takes into account whether a use of the
asset that is physically possible and legally permissible generates adequate
income or cash flows (taking into account the costs of converting the asset to
that use) to produce an investment return that market participants would
require from an investment in that asset put to that use.
ASC Paragraph 820-10-35-10C
Highest and best use is determined from the perspective of market participants,
even if the reporting entity intends a different use. However, a reporting entity’s
current use of a nonfinancial asset is presumed to be its highest and best use
unless market or other factors suggest that a different use by market participants
would maximize the value of the asset.
ASC Paragraph 820-10-35-10D
To protect its competitive position, or for other reasons, a reporting entity may
intend not to use an acquired nonfinancial asset actively, or it may intend not to
use the asset according to its highest and best use. For example, that might be the
case for an acquired intangible asset that the reporting entity plans to use
defensively by preventing others from using it. Nevertheless, the reporting entity
shall measure the fair value of a nonfinancial asset assuming its highest and best
use by market participants.
ASC Paragraph 820-10-35-10E
The highest and best use of a nonfinancial asset establishes the valuation premise
used to measure the fair value of the asset, as follows:
a. The highest and best use of a nonfinancial asset might provide maximum
value to market participants through its use in combination with other assets
as a group (as installed or otherwise configured for use) or in combination
with other assets and liabilities (for example, a business).
1. If the highest and best use of the asset is to use the asset in combination
with other assets or with other assets and liabilities, the fair value of the
asset is the price that would be received in a current transaction to sell the
asset assuming that the asset would be used with other assets or with other
assets and liabilities and that those assets and liabilities (that is, its
complementary assets and the associated liabilities) would be available to
market participants.
2. Liabilities associated with the asset and with the complementary assets
include liabilities that fund working capital, but do not include liabilities
used to fund assets other than those within the group of assets.
3. Assumptions about the highest and best use of a nonfinancial asset shall
be consistent for all of the assets (for which highest and best use is
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relevant) of the group of assets or the group of assets and liabilities within
which the asset would be used.
b. The highest and best use of a nonfinancial asset might provide maximum
value to market participants on a standalone basis. If the highest and best use
of the asset is to use it on a standalone basis, the fair value of the asset is the
price that would be received in a current transaction to sell the asset to market
participants that would use the asset on a standalone basis.
17.035 In applying the guidance on highest and best use, an entity should determine the
fair value for the asset in its current state. ASC Subtopic 820-10 states that the reporting
unit’s current use of the asset is considered the highest and best use unless market or
other factors suggest that a different use by market participants would maximize the
value of the asset. However, in determining the fair value, an entity should consider
whether a market participant would acquire the asset with the intent to change its legal
use. ASC Topic 805 states that in determining the highest and best use, the reporting
entity determines whether the use is legally permissible, financially feasible, and
physically possible. The reporting entity also should consider whether maximum value
would be provided to market participants by using the asset on a stand-alone basis or in
combination with other assets. See further discussion in Section J in KPMG Fair Value
Measurements - Questions and Answers.
17.036 In some situations, an entity may need to consider that a market participant could
acquire a property with the intent to change the zoning restrictions. A market participant
would do so if this was in its economic best interest. Although current zoning restrictions
are an attribute of a property and are a matter of law that could significantly affect fair
value, zoning restrictions are generally not permanent, and zoning changes are legally
permissible. Zoning restrictions on the use of property can be, and often are, changed,
and variances provided at the request of property owners (market participants) consider
the possibility of a zoning change when pricing the asset at the measurement date. If the
use was considered physically possible and legally permissible, the reporting entity
would need to determine if the use was financially feasible. This analysis is consistent
with ASC Subtopic 820-10’s market participant view as well as with the guidance on
accounting for costs of real estate projects in ASC Topic 970, Real Estate—General,
which provides “The fair value of a (land) parcel is affected by its physical
characteristics, its highest and best use, and the time and cost required for the buyer to
make such use of the property considering access, development plans, zoning restrictions,
and market absorption factors.” (Emphasis added.)
17.037 When a fair value measurement of a differently zoned asset contemplates a
change in the legal usage of the asset (e.g., zoning restrictions), the risks of the change
and the cost a market participant would incur to transform the asset should be considered
in the measurement.
17.038 When use of the asset in combination with other assets as a group is determined to
be appropriate and its highest and best use, the fair value measurement of the asset should
be based on the fair value that would be received in a sale or transfer of the group of
assets.
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17.039 This aggregation of assets for purposes of establishing the highest and best use
premise, which could include multiple units of account, is the unit of measurement that
should be used to measure the fair value for the individual units of account within the unit
of measurement. ASC paragraph 820-10-35-10 states that assumptions regarding highest
and best use should be consistent between the group of assets and the individual assets.
Determining the fair value of individual units of account within a unit of measurement
requires apportionment of the overall fair value measurement for the unit of measurement
to the individual units of account. This is illustrated in Example 17.4.
Example 17.4: Apportionment of Unit of Measurement to the Individual
Units of Account
ABC Corp. has two asset groups: Asset Group 1 and Asset Group 2. Each asset group
represents an individual unit of account. If sold separately, ABC would receive $100 for
Asset Group 1 and $100 for Asset Group 2. If sold together, ABC would receive $300 for
the two asset groups. Given these facts, the highest and best use of Asset Groups 1 and 2
is to be sold in combination. Therefore, the unit of measurement is the aggregation of
Asset Groups 1 and 2. Because ABC performed individual fair value measurements for
Asset Group 1 and Asset Group 2, and determined the fair values for each asset group,
one possible way of apportioning fair value to Asset Group 1 is by using the relative fair
values. Based on this methodology, $150 of the overall unit of measurement’s fair value
would be apportioned to Asset Group 1 ($100, the individual fair value for Asset Group
1, divided by $200, the aggregated individual fair values for Asset Groups 1 and 2,
multiplied by $300, the fair value measurement for the unit of measurement) and $150
would be apportioned to Asset Group 2.
Example 17.4a: Valuation of Assets That Are Subject to a Government
Grant
ABC Corp. acquires DEF Corp. in a business combination. Two years before the
acquisition, DEF received a grant from the local government to fund 33% of the cost of
certain tangible fixed assets, subject to the condition that it must employ a minimum of
250 full-time employees at all times during the subsequent five years. DEF is required
to repay the grant if it fails to meet this condition.
The assets subject to the grant had an original cost of $15 million, and the grant was $5
million. DEF accounted for the grant as a reduction of the cost of the assets, which
have a weighted-average 10-year useful life. On the acquisition date, the assets have an
aggregate net carrying amount of $8 million and an aggregate fair value of $11 million,
based on market participant assumptions about their highest and best use. A contingent
obligation to repay the $5 million grant exists if DEF does not continue to employ at
least 250 full-time employees for three more years.
ABC should record the assets subject to the grant at their full fair value of $11 million
on the acquisition date, i.e., on an unencumbered basis. The amounts recorded in the
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business combination are not affected by the fact that they were originally acquired
subject to a grant or by the possible obligation to repay the grant. Rather, the
contingent obligation to repay the grant should be evaluated as an assumed contingent
liability (see Section 7).
17.040 In addition to determining the highest and best use that will impact the valuation
premise, a valuation approach or combination of approaches should be used to determine
fair value of property, plant, and equipment. The table below presents certain selected
property, plant, and equipment and common valuation approaches to estimate their
acquisition-date fair values when the premise of value is assumed to be in combination
with other assets as a group.
Common Fair Value Measurement Concepts
Market
Approach
Income
Approach
Cost
Approach
Sales
Comparison
Method
Income
Capitalization
Method
Replacement
Cost New
Method
F
F
O
S
S
F
F
S
S
S
F
F
F
F
F
Plant and equipment
Real property
Land
Buildings
Personal property
Machinery and
equipment
Other
Leasehold improvements
Construction-in-progress
Labeling Key
F = Applied Frequently
O = Applied Occasionally
S = Applied Seldom
Sales Comparison Method
17.041 The sales comparison method is frequently used to measure the fair value of real
property (e.g., land and buildings) and occasionally used to measure the fair value of
personal property (e.g., machinery and equipment). This method identifies prices of
recent transactions between market participants (purchasers/sellers) for comparable
properties considered to be equally desirable substitutes for that subject property. Once a
reasonable substitute for subject properties is identified, adjustments to the prices of those
properties may be necessary to account for certain factors, including, but not limited to,
the condition of the property, location, size, capacity, age, timing of sale, occupancy and
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others. The adjusted prices of the comparable properties are then analyzed and reconciled
to conclude on an estimate of fair value of the acquired property.
Income Capitalization Method
17.042 The income capitalization method is used frequently to measure the acquisition-
date fair value of real estate assets and seldom used to measure certain machinery and
equipment in a business combination. Similar to a discounted cash flow model, the
income capitalization method estimates the future net cash flows expected to accrue
directly, or indirectly, from ownership of the property, discounted to their present values
using an appropriate discount rate from the perspective of a market participant. The
estimated net cash flows used in the analysis are based upon potential cash flows after
considering vacancy, collection allowances, and operating expenses. The cash flows at
the assumed time of reversion are capitalized at an appropriate capitalization rate to
derive an estimated terminal value. The fair value of the property is estimated by
discounting all future cash flows in the discrete period, as well as the terminal value, at an
appropriate discount rate. The key steps as part of the income capitalization method are:
(1) estimating the future net cash flows of the property; (2) identifying an appropriate
capitalization rate as part of identifying a terminal value; and (3) discounting the
estimated net cash flows to a single present value using an appropriate discount rate to
estimate fair value.
(Pre-ASC Topic 842*) Replacement Cost New Method
17.043 The replacement cost new (RCN) method can also be used to measure the fair
value of personal property (e.g., machinery and equipment) and other types of property
(e.g., leasehold improvements, construction-in-progress) in a business combination when
the premise of value is assumed to be in combination with other assets as a group. The
RCN method involves estimating the replacement or reproduction cost of the subject
property as if it were new (the replacement cost new) and deducting allowances for loss
in value caused by physical deterioration, functional obsolescence, and economic
obsolescence inherent in the subject property. The proper starting point in applying the
RCN method is estimating the replacement cost new of the subject property. This reflects
the cost of new property with similar utility as the subject property. In some instances,
the new property may be more desirable than the subject property because the
replacement property costs less to acquire, costs less to operate, or produces more
revenue. In other instances, the replacement property may be a reproduction or a replica
of the subject property with similar materials. The replacement or reproduction cost new
is then adjusted for depreciable factors such as physical deterioration, functional
obsolescence and economic obsolescence.
Property, Plant, and Equipment to Be Used
17.044 Property, plant, and equipment to be used by the acquirer is measured at the
acquisition-date fair value, taking into consideration the highest and best use from a
market participant perspective, whether or not that use is consistent with the entity’s
intended use of the property. If no observable market exists for the acquired assets, an
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acquirer should use one or a combination of the valuation methods as previously
discussed, to measure the fair value of the property, plant, and equipment.
Property, Plant, and Equipment to Be Sold (Held for Sale)
17.045 An acquired long-lived asset (disposal group) that will be sold is classified as held
for sale at the acquisition date if the sale is probable and expected to qualify for
recognition as a completed sale within one year, and the other criteria in ASC paragraph
360-10-45-9 are probable of being met within a short period (usually within three
months) following the acquisition (unless already met at acquisition date). The acquirer
should measure an acquired long-lived asset (or disposal group) that is classified as held
for sale at the acquisition date in accordance with ASC Section 360-10-35 (i.e., at fair
value less cost to sell). ASC paragraph 805-20-30-22
17.046 Costs to sell, according to ASC Section 360-10-35, are the incremental direct
costs to transact a sale, that is, the costs that result directly from and are essential to a sale
transaction and that would not have been incurred by the entity had it not decided to sell.
Those costs include broker commissions, legal and title transfer fees, and closing costs
that are incurred before legal title can be transferred. The costs exclude expected future
losses associated with the operations of a long-lived asset (disposal group) while it is
classified as held for sale. If the sale is expected to occur beyond one year as permitted in
limited situations, the costs to sell should be discounted. ASC paragraph 360-10-35-38
Mining Assets
17.046a Mining assets are comprised of mineral properties and rights. The following
guidance applies.
ASC Paragraph 930-805-30-1
An entity shall include value beyond proven and probable reserves in the value
allocated to mining assets in a purchase price allocation to the extent that a market
participant would include value beyond proven and probable reserves in
determining the fair value of the asset.
ASC Paragraph 930-805-30-2
An entity shall include the effects of anticipated fluctuations in the future market
price of minerals in determining the fair value of mining assets in a purchase price
allocation in a manner that is consistent with the expectations of marketplace
participants. Generally, an entity should consider all available information
including current prices, historical averages, and forward pricing curves. Those
marketplace assumptions typically should be consistent with the acquiring entity's
operating plans with respect to developing and producing minerals. It generally
would be inappropriate for an entity to use a single factor, such as the current
price or a historical average, as a surrogate for estimating future prices without
considering other information that a market participant would consider.
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INTANGIBLE ASSETS
Valuation Analysis
17.047 If an intangible asset meets either the separability criterion or legal-contractual
criterion under ASC Topic 805, the intangible asset is recognized and measured at its
acquisition-date fair value, with limited exceptions (e.g., reacquired rights), typically
through the use of a valuation technique, because an observable fair value for individual
intangible assets usually is not available. Most intangible assets acquired in a business
combination are intended to provide a direct or indirect return to the acquirer through an
increase in revenue, lower costs, or other economic benefits. The valuation technique(s)
should be those that best capture the value of those benefits.
17.048 Determining fair value of intangible assets can be measured using one or a
combination of the three valuation approaches identified in ASC Subtopic 820-10,
depending on facts and circumstances and the type of intangible assets being valued.
Several techniques have been developed to estimate the fair value of specific intangible
assets. This section discusses some of these methods under the three valuation
approaches of the market approach, income approach, and cost approach.
Market Approach
17.049 The market approach is used to value intangible assets based on recent sales of
similar intangible assets when there are known and observable markets or market data for
similar assets. Under the market approach, the value of an asset reflects the price at which
comparable assets are sold in recent transactions and under similar circumstances. Use of
the market approach requires comparable arm’s length transactions for the individual
intangible asset. If comparable transactions of similar assets are available, valuation
ratios are calculated and applied to the intangible asset. However, in practice there are
few comparable transactions involving comparable intangible assets within a reasonable
time frame. As a result, the market approach is not commonly used to value intangible
assets acquired in a business combination.
Income Approaches
Relief-From-Royalty Method
17.050 The relief-from-royalty method measures the fair value of an asset using a cost-
savings concept. This is based on the notion that, if the entity did not own the asset, it
would pay a royalty to a third party for the right to use that asset. Therefore, the value of
the asset is the fair value of the cost savings of not paying a royalty to a third party. For
example, this method would be used for intangible assets expected to be used actively
(e.g., brands).
17.051 The fair value of the asset is estimated based on the present value of the royalty
payments that the acquirer saves by owning the asset, based on a market participant
royalty rate. In many cases, the royalty rate is estimated based on market data for royalty
arrangements involving similar transactions and assets. Because there may be limitations
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on the availability of observable data, the valuation professional should develop
appropriate support for the royalty rate used.
Multi-Period Excess Earnings Method
17.052 The multi-period excess earnings method (MPEEM) is used to estimate the fair
value of an intangible asset based on a residual cash flow notion. The principle behind
this method is that the fair value of an intangible asset can be determined by estimating
the cash flows that can be generated by the entire business or asset group and deducting
the cash flows on all of the other assets that contribute to the cash flows (i.e., burdening
the cash flows with contributory asset charges). The excess cash flows are ascribable to
the intangible asset, and the fair value estimate is equal to the present value of those
excess cash flows. For example, this method would be used for customer relationships
and technology assets acquired in a business combination.
17.053 Contributory asset charges (CACs) used in the MPEEM also are called capital
charges or economic rents. Many implementation issues can arise when identifying and
calculating CACs and in estimating rates of return associated with each contributory
asset. The Appraisal Foundation issued guidance on:
• Considerations when selecting appropriate rates of return on, and in some
cases returns of, identified contributory assets when applying the MPEEM;
• Reconciliation of the MPEEM result to the fair value of the asset grouping;
• Treatment of negative working capital and one-time acquisition accounting
adjustments to working capital;
• Two potential calculations for determining fixed-asset CACs;
• Charges for elements of goodwill, other than assembled workforce;
• Simultaneous application of the MPEEM to multiple intangible assets that
share the same benefit stream; and
•
Comparison of the weighted-average cost of capital with the implied rate of
return on a transaction and the weighted-average return on assets.
17.054 Return on and Return of. CACs reflect the usage of contributory operating
assets, which may include working capital, fixed assets, and intangible assets. CACs
compensate for an investment in a contributory operating asset by reflecting the rates of
return on those assets that investors require. This represents the return on contributory
operating assets, which will be reflected in the CACs.
17.055 CACs also may capture the recovery of contributory assets, which is the return of
the contributory assets. Judgment is needed to determine whether returns of contributory
operating assets should be included in CACs. For example, cash flows may already
reflect reductions in the cash-flow stream for costs that are considered synonymous with
returns of the contributory operating asset. When specific cash flows representing returns
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of the contributory operating assets are reflected in the cash-flow stream, they would be
excluded from the CACs to avoid double-counting.
17.056 Reconciliation of Results of the MPEEM. Applying CACs under the MPEEM
should neither enhance nor diminish the fair value of other identifiable assets and
liabilities. Because CACs are viewed as an allocation of earnings to operating
contributory assets, the MPEEM should calculate a specific intangible asset fair value in
a manner that can be reconciled to the asset grouping fair value when the intangible
asset’s value is added to the other discrete operating asset and liability fair values.
17.057 Negative Working Capital. Unlike most other asset categories where CACs
allocate the cash-flow stream to other assets, which reduces the fair value of the
identifiable intangible asset, CACs for negative working capital represent an
enhancement to the fair value of the identifiable intangible asset. The Appraisal
Foundation’s guidance expresses the view that negative working capital generated in the
normal course of business reflects economic reality for some business models (e.g.,
negative operating cycle) and results in an enhancement of the value of the identifiable
intangible by creating a business model where customers are willing to pre-pay for goods
or services. However, reflecting negative working capital as an increase to the cash-flow
stream would not be appropriate in situations where negative working capital represents
an anomalous situation. Similarly, one-time business combination adjustments to
working capital (e.g., inventory step-ups, deferred revenue write-downs) do not represent
long-term working capital operating levels and should be excluded from the initial and
ongoing levels of working capital used to calculate CACs.
17.058 Calculating Fixed Asset CACs. The guidance describes two ways that may be
appropriate for calculating CACs for fixed assets other than land. Both can take into
consideration returns of and returns on the required level of fixed assets.
17.059 The Average Annual Balance calculation includes two separate charges. The
return of charge corresponds to the annual economic depreciation for both the fair value
of the contributory fixed assets and the estimated levels of future capital expenditures. It
is also used as an input in the determination of the average annual balance of the fixed
assets. The return on charge is based on the rate of return a market participant investing
in such assets would require, which is applied to the average annual balance of the
corresponding fixed assets.
17.060 The Level Payment calculation treats CACs as a series of level annual payments.
It is conceptually similar to the calculation of an amortizing loan payment. Unlike the
Average Annual Balance calculation, the Level Payment calculation presents CACs as
one charge comprising both returns on and returns of the required level of fixed assets.
Similar to the Average Annual Balance calculation, CACs estimated under the Level
Payment calculation are based on the rate of return that reflects the market participant
assessment of the investment’s risk and is applied to the fair value of the contributory
fixed assets and future capital expenditures. When used properly, the two calculations
should yield comparable results.
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17.061 CACs for Goodwill. In a business combination, assembled workforce is
subsumed into goodwill rather than being recognized as a separate intangible asset.
Nevertheless, the assembled workforce is typically an element of goodwill for which
CACs are taken. Furthermore, in an acquisition of assets that is not a business
combination, assembled workforce is sometimes recognized as an identifiable asset and is
measured based on its fair value. Other than assembled workforce, goodwill-related
CACs are expected to appear in MPEEM analyses infrequently, and when they are used,
an unrecognized asset should be identified as contributing to the cash-flow stream.
Applying the MPEEM to Multiple Assets within the Asset Grouping
17.062 There is diversity in practice in situations where two or more identifiable
intangible assets share the same cash-flow stream and where it might be appropriate to
measure each using the MPEEM (e.g., technology and customer-relationship intangibles).
A question arises about whether it is appropriate to simultaneously apply cross charges
between the identifiable intangible assets in the MPEEM computation. The guidance
discourages the use of cross charges and proposes that only one identifiable intangible
asset from the asset grouping should be valued using the MPEEM for a specific cash-
flow stream. A potential way to resolve the problem is to split the cash-flow stream into
more refined subsets of cash-flow streams. Alternatively, other valuation techniques
might be used to value other intangible assets in the asset grouping rather than attempting
to apply the MPEEM to multiple assets within the asset grouping. Alternative valuation
models include the relief from royalty, with and without, quadrant, and separation
methods.
Rates of Return on Contributory Assets
17.063 When an identifiable intangible asset is valued concurrent with a business
valuation, leading practices include an analysis comparing the weighted-average cost of
capital (WACC), implied rate of return (IRR) and weighted-average return on assets
(WARA). A WARA analysis displays rates of return associated with each major asset
class including the identifiable intangible asset that was valued using the MPEEM. The
guidance observes that the selected rates of return on contributory assets should reflect
the riskiness of those assets. Typically the risk profile of an entity’s assets increases as
one moves down its balance sheet (e.g., working capital generally is less risky than fixed
assets, which generally are less risky than intangible assets). There also should be a
correlation to how the assets are financed because, as the risk profile increases, the
weighting shifts from debt to equity.
17.064 If the analysis shows significant differences among the WACC, IRR, and WARA,
it may indicate a need to refine the existing analysis. The process may include altering
preliminary rate of return estimates for the identifiable intangible asset or for some of the
CACs. Additionally, if the asset grouping fair value assumes a nontaxable transaction
structure, the WARA analysis may need to reflect a hypothetical adjustment as if the
transaction were taxable, because the portfolio of assets may have been individually
valued using a taxable-transaction premise.
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Greenfield Method
17.064a The Greenfield Method is frequently used to value licenses (or other operating
rights), particularly when the license's benefit significantly exceeds its cost. The
underlying theory of the Greenfield Method is that a business is assembled around a
pivotal asset (referred to as the subject asset). The subject asset’s existence is the impetus
for additional investments in complementary assets to create an operating entity. In other
words, there would be no need to assemble the total asset complement without the subject
asset. The license or operating rights driving the business are generally scarce, are often
granted or regulated by a government, and are common in these industries:
• Television
• Radio
• Wireless telecommunications
• Franchising
• Casino and gaming
17.064b Because the Greenfield Method isolates the cash flow attributable to the subject
asset, it is considered a direct valuation method as described in ASC paragraph 805-20-
S99-3. The Greenfield Method is often compared to the MPEEM, as both methods are
used to value pivotal assets of a company. Unlike the MPEEM, however, the Greenfield
Method deducts the costs associated with assembling a complementary asset base
through explicit cash outflows to build or purchase the supporting assets. The MPEEM
deducts economic rents – contributory asset charges – instead of deducting the costs to
assemble the contributory asset base.
17.064c The Greenfield Method is often applied when:
• The license is critical to the business and generally considered indefinite in
nature (e.g., where revocation rights are minimal);
• The industry has significant physical or legislative barriers to entry;
• There is a scarcity of licenses accessible to the industry (i.e., not situations
where non-exclusive rights are routinely granted to all operators); or,
• The license allows possession of an underlying resource or asset and therefore
denies its use to others.
Applying the Greenfield Method
17.064d The assumptions used in applying the Greenfield Method should reflect market
participant expectations, industry standards, and trends in the respective markets as of the
valuation date. Entities should consider technological advances throughout the forecast
period to the extent they may affect the cash flows of market participants. Thus, the
assumptions about returns, risks and growth patterns may be materially different from the
actual, historical experience of the company that currently owns the asset.
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17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
17.064e Typically the Greenfield Method considers at least two distinct stages:
• The ramp-up period, encompassing the initial build-out of the business until
mature margins and earnings are reached; and,
• Mature business operations or the terminal value.
17.064f Application of the Greenfield Method differs across industries because
determining the fair value should be driven by the economics underlying the value of the
subject asset. Generally, the Greenfield method requires a wide range of inputs and
assumptions, including the length of the ramp-up period, mature earnings projections,
capital expenditures and depreciation, working capital, tax rate, terminal value, discount
rate, and tax amortization benefit. It may be challenging to gather all required data and
make all relevant assumptions.
17.064g Ramp-Up Period. An entity should estimate the time period necessary to
achieve a stable, mature business assuming the new business begins only with the subject
asset. This ramp-up period should be based on industry norms for the subject asset and
therefore may differ from the actual manner in which the business was formed and is
currently operated. During this period, the projected earnings typically ramp up from zero
or a negative figure to a mature level which in most cases is positive. The length of the
ramp-up period may be influenced by various factors, such as the time to build out the
required infrastructure (e.g., a wireless network in the case of a wireless spectrum
license) or the time to acquire customers and reach a mature level of market share. Often
a company would experience significant start-up expenses and inefficiencies resulting in
substantial early period losses. Combined with the initial capital expenditures, the general
expectation is that cash flows are negative in the initial years. The specifics associated
with the ramp-up period may differ depending on the asset, industry, region, and other
factors.
17.064h Mature business operations. The long-term estimate of cash flows for the
subject asset should be based on market participant assumptions for market share,
revenue and operating costs. The long-term outlook of the business owning the subject
asset, however, is often used as a proxy. In that case, mature Greenfield Method cash
flows converge with the projections of the existing business. Alternatively, there might be
circumstances in which the existing business is not representative of a market participant
long-term expected mature state. Examples can be existing businesses that have
significant company-specific synergies with other assets or business units that are
independent of the subject asset, or an existing business that does not fully utilize the
potential of the subject asset (e.g., using an FCC license for strictly educational or
religious broadcasting when it is available for full commercial use). As with the ramp-up
period, the projection of the mature level of the business is subjective and thus requires
consideration of industry benchmarks, market conditions, etc. to derive a market
participant view. Depending on the industry, reliable market data may be difficult to
obtain. Assumptions necessary to apply the Greenfield Method may be easier to support
for industries where market studies of financial projections are available.
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17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
17.064i Terminal Value. Assets typically valued using the Greenfield Method generally
have indefinite useful lives under ASC paragraph 350-30-35-4 and thus require a terminal
value. Some of those assets may need to be renewed regularly. However, the example in
paragraphs 350-30-55-11 through 55-13 indicates that if renewal is expected indefinitely
with minimal legal, regulatory, economic or technological hurdles and there is a history
of renewal for the asset, it would be deemed to have an indefinite useful life.
17.064j Tax Effects. To value the subject asset, an entity also must consider the relevant
tax rate, tax losses created during the ramp-up period, and the depreciation of assets for
tax purposes. During the initial ramp-up period, a business may generate significant
losses. As the Greenfield Method theoretically analyzes the subject asset in isolation, an
entity should assume that net operating losses generated by the subject asset are carried
forward to offset earnings generated by that asset in future periods, rather than assuming
that the net operating losses are used immediately to offset earnings from other unrelated
assets in the business. Furthermore, only net operating losses generated by the subject
asset should be considered in its valuation. Acquired or future net operating losses of the
existing business are generally excluded from a Greenfield Method valuation.
17.064k To the extent that the subject asset qualifies as an amortizing intangible asset for
tax purposes in the applicable jurisdiction, a tax amortization benefit is included in the
valuation.
17.064l Discount Rate. Because the cash flows portray an entity using the subject asset,
a WACC calculation for the hypothetical new business is typically used and is based on
the long-term capital structure of a market participant and its associated cost of debt and
equity. In practice, the WACC of the assembled business is often used as a starting point.
Depending on the relative risk profile of the cash flows used, the discount rate in the
analysis may differ from the WACC associated with the combined business operations of
the company owning the subject asset, particularly if the market participant’s view of the
asset differs from its current use by the existing business; for example, because of
company-specific factors or synergies. An entity should consider the start-up nature of
the cash flows, the size of the operations, and the resulting riskiness of the cash flows
when selecting the appropriate discount rate.
Incremental Cash Flow Method
17.065 Similar to the multi-period excess earnings method, the incremental cash flow
method is used to estimate the fair value of an intangible asset based on a residual cash
flow notion. This method measures the benefits (e.g., cash flows) derived from ownership
of an acquired intangible asset as if it were in place, as compared to the acquirer’s
expected cash flows as if the intangible asset were not in place (i.e., with-and-without).
The residual or net cash flows of the two models is ascribable to the intangible asset and,
when discounted to its present value, provide an estimate of its fair value. The present
value estimate should be determined using a discount rate that market participants would
demand in light of the risks involved.
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17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
Cost Savings Method
17.066 The cost savings method values the asset by calculating the present value of the
cost savings that an acquirer estimates would be obtained through owning an existing and
functioning asset, provided that the cost savings would be available to market participants
if they owned the intangible asset. These cost savings represent a measure of the benefits
of ownership of the asset.
Cost Approach
17.067 The cost approach values the intangible asset based on the costs that would be
incurred to re-create the intangible asset. Costs include directly attributable costs such as
research and development. It is highly unusual for a cost approach to be used to value
intangible assets. Intangible assets, especially those valued in combination with other
assets or assets and liabilities as a group, possess value that transcends the estimated sum
of the costs to re-create the asset.
Intangible Assets Commonly Acquired in Business Combinations
17.068 The table and discussion below identify several intangible assets that are
commonly acquired in business combinations, and some of the commonly used
techniques for estimating the acquisition-date fair value of those assets. The list is not all-
inclusive, and is presented for illustration purposes only.
Common Fair Value Measurement Concepts
Valuation Approaches
Market
Relief-
From-
Royalty
Method
Income
Multi-Period
Excess
Earnings
Method
Incremental
Cash Flow
Method
Cost
O
S
S
S
O
O
S
S
F
S
S
S
S
O
F
O
S
S
F
F
O
F
O
F
O
F
O
O
S
S
O
S
S
S
S
S
F
S
F
S
Intangible Assets
Marketing related
Trademarks and trade
names
Non-compete agreements
Customer related
Customer relationships
Order/production backlog
Customer lists
Artistic-related
Musical works
Technology based
Patented and unpatented
technology
In-process research and
development
Labeling Key
F = Applied Frequently
O = Applied Occasionally
S = Applied Seldom
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17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
Trademarks and Trade Names
17.069 Trademarks and trade names (branding or brand) are used by entities to
differentiate the source of a product and to distinguish it from competitors’ similar
products. Trademarks and trade names are frequently measured using the relief-from-
royalty method. Key considerations when applying this technique when measuring
trademarks and trade names include:
•
Identifying the benefit stream attributed to the trademarks and trade names;
• Understanding the planned use for the trademarks and trade names by the
acquirer and whether it is similar to the expected uses by market participants;
• Selecting a royalty rate from market comparable agreements or previous
agreements for the asset;
• Establishing a market participant tax rate;
• Determining whether a tax amortization benefit is appropriate; and
• Determining whether a terminal value is appropriate in the calculation.
Noncompete Agreements
17.070 Noncompete agreements are contracts that place restrictions on an entity or
former owners of an entity and their ability to compete with the acquirer. The restrictions
relate to specified markets and/or specified products or activities for a defined period of
time. Noncompete agreements are often measured using the incremental cash flow
method. Key considerations when applying this technique include:
•
Identifying the benefit stream attributed to the noncompete agreement;
• Understanding of the period covered by the agreement;
• Estimating the probability of competition absent the agreement;
• Assessing the business impact of competition absent the noncompete
agreement;
• Establishing a market participant tax rate; and
• Determining whether a tax amortization benefit is appropriate.
Customer Relationships
17.071 Customer relationships acquired in a business combination may arise from
contractual rights or through means other than contracts. For example, a customer
relationship may exist between an entity and its customer if (a) the entity has information
about the customer and has regular contact with the customer, and (b) the customer has
the ability to make direct contact with the entity. In many circumstances, intangible assets
representing customer relationships are a significant element of the acquiree’s fair value.
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17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
Customer relationships are often measured using the multi-period excess earnings
method. Key considerations when applying this technique include:
•
•
Identifying one or multiple types of relationships to be measured at fair value;
Identifying revenue or cash flow attributable to existing customer
relationships (excluding order or production backlog, deferred revenue, and
any separately recognized contract assets or contract liabilities after adoption
of ASC Topic 606);
• Understanding revenue growth for existing customers;
• Estimating remaining contract lives or an attrition rate for existing customers;
• Removing sales and marketing expenses incurred by the entity to attract new
customers;
• Quantifying market participant synergies;
• Calculating contributory asset charges;
• Establishing a market participant tax rate; and
• Determining whether a tax amortization benefit is appropriate.
Order/Production Backlog
17.072 Order or production backlog arises from unfulfilled contracts such as purchase or
sales orders at the acquisition date. Order or production backlog is often measured using
the multi-period excess earnings method because the benefit stream of the backlog may
be distinct from the customer relationship intangible asset. Key considerations when
applying this technique include:
•
Identifying revenue or cash flow attributed to existing, but unfulfilled orders
(excluding any separately recognized contract assets or contract liabilities
after adoption of ASC Topic 606);
• Understanding the applicable costs related to the revenue or cash flow stream
and adjusting to reflect market participant assumptions, if necessary;
• Determining the period over which the orders will be fulfilled;
• Calculating contributory asset charges;
• Establishing a market participant tax rate; and
• Determining whether a tax amortization benefit is appropriate.
Customer Lists
17.073 A customer list consists of information about customers, such as their names and
contact information. The list may be in the form of a database with other information,
such as customer order histories and demographic information. A customer list is often
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17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
measured using the cost savings method. Key considerations when applying this
technique include:
•
Identifying the costs incurred to collect, organize, and input the data into a
storage system;
• Understanding the applicable costs related to development and maintenance of
the software system used to store the data;
• Determining all other applicable costs related to the recreation of the customer
list, including opportunity costs;
• Establishing a market participant tax rate; and
• Determining whether a tax amortization benefit is appropriate.
Musical Works and Rights
17.074 Musical works and rights such as musical compositions, represent works of art
that may be income producing. The holder can transfer a copyright, either in whole
through an assignment or in part through a licensing agreement. Rights to musical works
are seldom transacted on an individual basis. Instead, it is common for musical works, or
the rights to market them, to be aggregated as a portfolio of income generating assets.
17.075 Because musical works and rights generate income, they may be measured under
an income approach using a discounted cash flow method. Typically, this occurs when
the portfolio constitutes a majority or all of the assets of the business. When musical
works and rights exist among other income generating assets and the related cash flows
cannot be separated, the portfolio of musical works and rights is frequently measured
using the multi-period excess earnings method. Key considerations when valuing artist-
related intangible assets include:
•
Identifying revenue or cash flow attributed to the artist-related works and
rights;
• Understanding the applicable costs related to the artist-related works and
rights;
• Evaluating similarities and differences between the subject asset and the
observed peer group;
• Determining the period over which the artist-related works and rights will be
monetized;
• Calculating contributory asset charges, if appropriate;
• Establishing a market participant tax rate; and
• Determining whether a tax amortization benefit is appropriate.
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17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
Patented and Unpatented Technology (Including Software)
17.076 Technology-related assets comprise a set of technical processes, intellectual
property, and the institutional understanding within an organization with respect to
various processes and products. Those assets can be classified as patented and unpatented
technology. Generally, advanced technology is covered by a patent or similar legal
protection.
17.077 Patented and unpatented technology is frequently measured using the relief-from-
royalty method or cost savings method. Key considerations when applying these
techniques include:
• Evaluating if the asset provides a return (e.g., generates revenues or cash
flows), reduces expenses, or provides some other economic benefit;
• Understanding the planned use for the asset by the acquirer, and whether that
planned use is similar to or different from potential use by market participants;
•
Identifying depreciable factors (e.g., erosion of value) and the remaining
economic life;
• Quantifying costs incurred to develop the asset and required future costs;
• Establishing a market participant tax rate; and
• Determining whether a tax amortization benefit is appropriate.
In-Process Research and Development
17.078 Research and development projects that are underway but not completed are
referred to as in-process research and development (IPR&D). IPR&D acquired in a
business combination satisfies the definition of an asset for recognition and measurement,
because the observable exchange at the acquisition date provides evidence that the parties
to the exchange expect future economic benefits to result from the IPR&D (see
considerations in evaluating whether IPR&D qualifies as an asset in a business
combination in Section 7).
17.079 The income approach is commonly used to value IPR&D assets. Techniques
under the income approach include, but are not limited to, the multi-period excess
earnings, relief-from-royalty, decision tree, and split methods. These methods are
described in Chapter 1 of the AICPA Accounting and Valuation Guide, Assets Acquired
to Be Used in Research and Development Activities (IPR&D Guide). Key considerations
when applying the multi-period excess earnings method include:
• Selecting prospective financial information that best reflects the consideration
transferred;
• Confirming the existence of assets acquired to be used in research and
development activities, including IPR&D;
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17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
• Determining the cash flows related to the reliance on core or other
technologies;
• Eliminating the effects of non-IPR&D activities from the prospective financial
information;
• Capturing all expenses related to the IPR&D activity, including any third
party royalty payments or future milestone obligations related to previous
licenses of products employed in the IPR&D;
• Quantifying market participant synergies;
• Calculating contributory asset charges;
• Establishing a market participant tax rate; and
• Determining whether a tax amortization benefit is appropriate.
17.080 A business combination may result in the acquisition of assets that an entity does
not intend to actively use but does intend to prevent others from using. Such assets are
commonly referred to as defensive intangible assets or locked-up assets. Under ASC
Topic 805, an acquirer recognizes and measures all intangible assets, including defensive
intangible assets, at fair value determined in accordance with ASC Subtopic 820-10. ASC
Subtopic 350-30 provides guidance on how defensive intangible assets should be
accounted for subsequent to their acquisition. When an IPR&D asset is acquired and
intended to be used for defensive purposes, the accounting treatment will depend on what
the acquired IPR&D asset is intended to defend. Refer to Section 12 for additional
discussion of the accounting for defensive intangible assets.
LONG-TERM CONSTRUCTION-TYPE CONTRACTS (PRE-ASC TOPIC 606)
17.081 Long-term construction-type contracts (LTCCs) consist of services to design,
engineer, fabricate, construct, or manufacture tangible assets where service periods
extend over long periods of time, and the right to receive payment depends on
performance and completion of those services.
17.082 As outlined in ASC Topic 820 and discussed starting at Paragraph 17.049, there
are three valuation approaches that may be considered to value an intangible asset: the (a)
income approach, (b) market approach, and (c) cost approach. An intangible asset that is
unique and cannot be readily replaced is normally valued using an income approach. An
income approach is generally used because the intangible asset is expected to generate
measureable future cash flows. The market approach is usually not used to value
intangible assets because of the lack of market transactions for similar individual assets.
If an intangible asset is easily re-created and the principle of substitution (a prudent
investor would pay no more for an asset than the amount necessary to replace the asset) is
valid for that asset, then the cost approach is typically used. The valuation approach(es)
should be determined based on whether the LTCC is unique, easily re-created, or there is
available market data.
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17.082a An acquired LTCC may consist of the following units of account:
17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
The four units of account are commonly measured as follows:
• Contract backlog. If the contract is unique or not easily replaceable, then
backlog is typically valued using an income approach (e.g., the multi-period
excess earnings method). If the contract is easily replaceable, then backlog is
typically valued using a cost approach via the avoided costs to acquire the
contract. See Paragraphs 17.052 and 17.067 for additional discussion of the
multi-period excess earnings method and the cost approach, respectively.
• Off-market component. This is an asset or liability to the extent that the
terms of the contract are above or below what a market participant could
achieve at the time of the acquisition. This unit of account is often valued
using an income approach via the off-market differential as of the acquisition
date. See Paragraphs 7.095 through 7.096 for additional discussion of
accounting for contracts with favorable or unfavorable terms.
• Asset (liability) to the extent that costs exceed billings (vice versa). There
are times when the carrying amount on the acquiree's balance sheet
approximates fair value. If this is not the case, then using a market or cost
approach may be appropriate, taking into account costs to complete and a
profit unit of account. See Paragraphs 17.049 and 17.067 for additional
discussion of the market and cost approaches, respectively.
• Customer relationship. The customer relationship intangible asset may be
recognized separately from the LTCC and is often measured using an income
approach (e.g., the multi-period excess earnings method or the distributor
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17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
method). See Paragraphs 17.071 and 17.052 for additional discussion of
valuing customer relationships and the multi-period excess earnings method,
respectively.
These units of account can be incorporated into one valuation approach or they may be
estimated separately using various valuation approaches. It is important to understand the
units of account so as not to double count value. Regardless of the valuation approach
applied, all cash flow components of an LTCC should be accounted for in the fair value
measurement.
Accounting under the Completed Contract Method#
17.083 While the fair value of the units of account are not affected by the method of
accounting for LTCCs, the accounting entries for the acquirer differ based on whether the
acquirer uses the completed contract or the percentage of completion method. If the
acquiring entity uses the completed contract method to account for the acquired contract,
the costs incurred and customer billings after the acquisition date should be recognized as
costs incurred (an asset) and billings (a liability), respectively, similar to a new contract
where the completed contract method would be applied. On completion of the contract,
the costs incurred subsequent to the acquisition should be charged to costs of sales and
the billings should be offset against the asset or liability established in purchase
accounting with the difference recognized as revenue.
Example 17.5: Accounting for LTCC (Completed Contract Method)
ABC Corp. acquires DEF Corp. in a business combination on December 31, 20X4. At
December 31, 20X4, DEF is party to a LTCC to build a custom engineered widget for
Customer. The relevant terms of the contract as of December 31, 20X4:
Amount remaining to be billed under the contract = $200
Estimated costs to complete the widget = $50
For ease of illustration, assume that ABC determined that the LTCC was at market. ABC
records a LTCC asset (representing the fair values of the contract backlog of $10 and the
costs in excess of billings of $95) of $105 on the acquisition date.
ABC separately determines the fair value of the customer relationship intangible asset
and concludes the life of that asset is longer than the life of the LTCC asset. Therefore,
ABC separates the customer relationship intangible asset and amortizes it over the
remaining useful life of the customer relationship. The amortization of the customer
relationship intangible asset is omitted from the example journal entries below for
simplicity.
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468
17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
Completed Contract Accounting – Post-Acquisition:
ABC appropriately uses the completed contract method of accounting for the acquired
contract. ABC incurs $55 in costs to complete the contract and receives $200 from
Customer according to the remaining terms of the contract. The journal entries to record
these transactions are:
(1) Costs incurred (Project Widget)
Account payable
Debit
55
(To recognize costs incurred to complete the contract.)
(2) Cash
Billings (Project Widget)
200
Credit
55
200
(To recognize receipt of cash in accordance with terms of acquired contract.)
ABC would report the fair value of the contract at acquisition ($105), the costs incurred
subsequent to acquisition ($55), and the billings received ($200) as a net liability (billings
in excess of costs incurred), assuming the contract was not complete at its next interim
reporting date.
On completion of the contract, the journal entries ABC records are:
(3) Billings
200
Fair value of contract acquired
Revenue
105
95
(To recognize revenue associated with work performed subsequent to the acquisition
date.)
(4) Cost of goods sold
Costs incurred (Project Widget)
55
55
(To recognize the cost of goods sold related to the portion of work completed
subsequent to the acquisition date.)
If ABC had identified an off-market unit of account to the LTCC contract, the off-
market unit of account would have been recorded as an asset or liability on the
acquisition date and would be reversed into revenue when the contract was complete.
Accounting under the Percentage of Completion Method#
17.084 While the fair value of the units of account is not affected by the method of
accounting for LTCCs, the accounting entries for the acquirer differ based on whether the
acquirer uses the completed contract or the percentage of completion method. If the
acquiring entity uses the percentage of completion method to account for the acquired
contract subsequent to the acquisition, the accounting at acquisition is the same as used
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469
17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
for the completed contract method. However, subsequent to the acquisition, in
accordance with the percentage of completion method, the acquiring entity would
determine the amount of costs and revenue to recognize in each reporting period until
completion of the contract. The calculation should be based on the measure of progress
toward completion of the performance obligation that was assumed by the acquiring
entity on acquisition of the contract and not through reference to the progress toward
completion of the project as a whole.
Example 17.6: Accounting for LTCC (Percentage of Completion Method)
Assume the same facts as Example 17.5 except ABC Corp. appropriately uses the
percentage of completion method to account for the acquired contract subsequent to the
date of acquisition. At acquisition, ABC assigns the same amount ($105) to the contract.
In addition, ABC estimates that the contract will be completed at June 30, 20X5.
Percentage of Completion
During the three-month period ending March 31, 20X5, ABC incurs $40 in costs toward
completion of the contract and bills and receives $150 from Customer according to the
terms of the contract. As of March 31, 20X5, ABC estimates that the remaining costs to
complete the widget are $15. ABC uses the cost-to-cost method to estimate its progress
toward completion of the obligation assumed. As a result, ABC estimates that its progress
toward completion percentage is 73% ($40/$55). Based on the current estimate of costs to
complete the contract, the contract margin is estimated at $40 (billings of $200 less fair
value of contract at acquisition date of $105 and costs to be incurred subsequent to
acquisition of $55). The journal entries to record these activities are:
(1) Costs incurred (Project Widget)
Account payable
Debit
40
(To recognize costs incurred toward completion of the contract.)
(2) Cash
Billings (Project Widget)
150
(To record cash received in accordance with terms of acquired contract.)
(3) Cost of goods sold
Costs incurred (Project Widget)
40
Credit
40
150
40
(To recognize 73% of the total costs expected to be incurred to complete the widget.)
(4) Costs incurred (Project Widget)
69
Revenue
(To recognize revenue earned related to the progress toward completion.)
69
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The amount of revenue recognized is calculated as the sum of the cost of sales and
projected profit earned to date using the percent of progress toward completion (($55 +
$40) * 73%).
During the three months ended June 30, 20X5, ABC incurs $15 to complete the widget
and receives $50 in accordance with the terms of the contract. ABC should record the
journal entries as:
(5) Costs incurred (Project Widget)
Account payable
Debit
15
(To recognize costs incurred toward completion of the contract.)
(6) Cash
Billings (Project Widget)
50
(To record cash received in accordance with terms of acquired contract.)
(7) Cost of goods sold
Costs incurred (Project Widget)
15
Credit
15
50
15
(To recognize the cost of goods sold related to activities of the current period.)
(8) Costs incurred (Project Widget)
26
Revenue
26
(To recognize revenue associated with work performed subsequent to the acquisition
date. ($55 cost + $40 margin) - 69 of revenue previously recognized)
(9) Billings
Costs incurred (Project Widget)
Fair value of contract acquired
(To close the contract.)
200
95
105
In both examples the total revenue recognized subsequent to the acquisition date is
$95. This is appropriate because the underlying facts and circumstances are presumed
to be the same. The method of recognizing revenue under contract accounting does not
affect the total revenue to recognize subsequent to the acquisition; it affects the timing
of recognition only. Also note the method of accounting for the contracts prior to the
acquisition date has no bearing on the accounting by the acquiring entity.
CONTRACTS WITH CUSTOMERS (AFTER ADOPTION OF ASC TOPIC 606##)
17.084a ASC Topic 606 was effective for public entities for annual periods beginning
after December 15, 2017 and for all other entities for annual periods beginning after
December 15, 2018. After adoption, an acquirer must account for an acquiree's contracts
with customers (revenue contracts) under ASC Topic 606. The accounting for revenue
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17. Determining the Fair Value of Assets Acquired
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contracts acquired in a business combination is similar to the accounting for acquired
long-term construction-type contracts before adoption of ASC Topic 606.
17.084b As outlined in ASC Topic 820, there are three valuation approaches that may be
considered to value an intangible asset: the (a) income approach, (b) market approach,
and (c) cost approach. An intangible asset that is unique, generates cash flows and cannot
be readily replaced is normally valued using an income approach. An income approach is
generally used if the intangible asset is expected to generate measureable future cash
flows. The market approach is usually not used to value intangible assets because of the
lack of market transactions for similar individual assets. If an intangible asset is easily re-
created and the principle of substitution (a prudent investor would pay no more for an
asset than the amount necessary to replace the asset) is valid for that asset, then the cost
approach is typically used. The valuation approach(es) should be determined based on
whether the contract with the customer is unique, easily re-created, or there is available
market data.
17.084c An acquired contract with a customer may affect the following units of account:
Those units of account are commonly measured as follows.
• Contract backlog. If the contract is unique or not easily replaceable, then
backlog is typically valued using an income approach (e.g., the multi-period
excess earnings method). If the contract is easily replaceable, then backlog is
typically valued using a cost approach via the avoided costs to acquire the
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17. Determining the Fair Value of Assets Acquired
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contract. See Paragraphs 17.052 and 17.067 for additional discussion of the
multi-period excess earnings method and the cost approach, respectively.
• Off-market component. This is an asset or liability to the extent that the
terms of the contract are above or below what a market participant could
achieve at the time of the acquisition. This unit of account is often valued
using an income approach via the off-market differential as of the acquisition
date. See Paragraphs 7.095 through 7.096 for additional discussion of
accounting for contracts with favorable or unfavorable terms.
• Contract asset or liability. See Paragraphs 17.084d through 17.084e for a
discussion of contract assets and 17.084f through 17.084k for a discussion of
contract liabilities.
• Customer relationship. The customer relationship intangible asset may be
recognized separately from the contract and is often measured using an
income approach (e.g., the multi-period excess earnings method or the
distributor method). See Paragraphs 17.071 and 17.052 for additional
discussion of valuing customer relationships and the multi-period excess
earnings method, respectively.
These units of account can be incorporated into one valuation analysis or they may be
estimated separately using various valuation techniques. It is important to understand the
units of account to avoid double counting value. Regardless of the valuation approach
applied, all cash flow components of a contract with a customer should be accounted for
in the fair value measurements.
Contract Assets (after Adoption of ASC Topic 606##)
17.084d Contract assets acquired in a business combination should be measured at their
acquisition date fair values.
17.084e Contract assets are rights to receive consideration from a customer that are
conditional on something other than the passage of time, such as completing all
performance obligations under the related contract. In many cases, the acquiree's carrying
amount may approximate fair value. Some factors that could affect the fair value of the
contract asset include market rates of interest, the customer's creditworthiness, and the
acquiree's ability to satisfy the remaining performance obligations. If the carrying amount
on the acquiree's balance sheet does not approximate fair value, using a market or income
approach to determine fair value may be appropriate. See Paragraphs 17.049 and 17.067
for additional discussion of the market and cost approaches, respectively. Care should be
taken not to double count the cash flows used to measure the contract asset with those
used to value contract-related intangible assets, such as order backlog and customer
relationships.
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17. Determining the Fair Value of Assets Acquired
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Contract Liabilities (after Adoption of ASC Topic 606)
17.084f Contract liabilities are obligations to transfer goods or services to a customer, for
which an entity either has received consideration or has an unconditional right to receive
consideration.
17.084g There was an Issue for consideration on the agenda of the EITF (Issue 18-A)
about how to account for contract liabilities assumed in a business combination after the
adoption of ASC Topic 606. The EITF considered whether the definition of a
performance obligation should be used to recognize a contract liability assumed in a
business combination or if a liability should be recognized only when the acquirer has a
remaining legal obligation.
17.084h Prior to the adoption of ASC Topic 606, existing practice was to recognize
deferred revenue based on the notion of a legal obligation (based on EITF Issue No. 01-3,
"Accounting in a Business Combination for Deferred Revenue of an Acquiree," which
was nullified by Statement 141R). For example, consider a 10-year license of character
images in exchange for a fixed up-front payment. One year into the license term, the
licensor is acquired by another entity. The acquirer would recognize a liability related to
its remaining legal obligations from this contract, which are likely to be minimal, because
the acquiree has already provided the images to the customer. In contrast, ASC Topic 606
indicates the license is a performance obligation satisfied over time and that there would
be a remaining performance obligation at the acquisition, which could give rise to a
contract liability. Therefore, if the performance obligation definition is used, the acquirer
may reach a different conclusion about whether to recognize a contract liability.
17.084i – 17.084j Paragraphs not used.
17.084k As of the date of this publication, the issue has been removed from the EITF
agenda and subsumed into the FASB's research project, "Recognition and Measurement
of Revenue Contracts with Customers under Topic 805. "We understand that the SEC
staff expects entities to continue to apply the legal obligation notion from EITF 01-3
absent further standard setting. Entities, valuation professionals, and auditors are
encouraged to consult with subject matter experts to obtain the latest information about
this issue.
Accounting for Acquired Revenue Contracts (after Adoption of ASC Topic 606)##
17.084l Generally, the acquirer must determine the accounting for each revenue contract
acquired in a business combination individually. However, under ASC paragraph 606-10-
10-4, as a practical expedient, an entity may apply the guidance in ASC Topic 606 to a
portfolio of contracts (or performance obligations) if the entity reasonably expects that
the effect of applying the guidance to the portfolio would not differ materially from
applying it on a contract-by-contract basis. We believe this practical expedient also
applies to an acquirer's accounting for an acquiree's revenue contracts after the
acquisition date.
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17. Determining the Fair Value of Assets Acquired
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17.084m When determining post-acquisition revenue recognition under Topic 606, an
acquirer should reconsider all of the steps in the revenue model, based on the facts and
circumstances at the acquisition date. Those steps are:
• Step 1: identify the contract with the customer. Generally, we expect that
an acquirer's evaluation of this step would not differ from the acquiree's
evaluation.
• Step 2: identify the performance obligations. The performance obligations
identified by the acquirer should be based on the remaining goods or services
to be transferred to the customer after the acquisition date. Goods and services
transferred to the customer by the acquiree before the acquisition date should
be excluded from this evaluation.
• Step 3: determine the transaction price. We believe the new transaction
price consists of the remaining consideration under the contract less (plus) the
amount of a contract asset (liability) recognized in the acquisition accounting.
• Step 4: allocate the transaction price to the performance obligations. The
newly calculated transaction price is allocated to the remaining performance
obligations.
• Step 5: recognize revenue when (or as) performance obligations are
satisfied. For a performance obligation satisfied over time, an acquirer should
consider only post-acquisition activities in both the numerator and
denominator to measure progress toward complete satisfaction, regardless of
whether it uses an input or output method.
17.084n See KPMG Handbook, Revenue recognition, for additional guidance on
accounting for revenue contracts.
Example 17.6a: Accounting for an Acquiree's Revenue Contract after
Adopting ASC Topic 606
Acquirer acquires Acquiree in a business combination on April 30, 20X9. Acquiree has a
contract with a customer to perform a daily cleaning service at a customer's properties.
The contract term runs from January 1, 20X9 to December 31, 20X9. The fee for the
cleaning services is $1,000 per month, billable quarterly in arrears. The cleaning service
is a performance obligation satisfied over time, because the customer receives and
consumes the benefits of Acquiree's performance as Acquiree performs. At the
acquisition date, Acquiree had recognized revenue of $4,000 under the contract (using a
time-based measure of progress) and had a contract asset on its books for $1,000.
Assume that the acquirer determines the following fair values for the individual units of
account at the acquisition date:
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17. Determining the Fair Value of Assets Acquired
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Contract asset
Backlog intangible asset
Favorable contract intangible asset
Estimated Fair Value
$960
240
160
After the acquisition date, the transaction price is $8,040, calculated as the remaining
billings under the contract ($9,000) less the contract asset ($960). Acquirer uses a time-
based measure of progress, resulting in $1,005 of revenue per month as the performance
obligation is satisfied ($8,040/8). Acquirer also amortizes the favorable contract
intangible asset against revenue, resulting in a $20 per month reduction of revenue, to
$985 per month. Finally, Acquirer recognizes $30 expense per month as the backlog
intangible asset is amortized ($240/8). Alternatively, Acquirer could recognize the
amortization of the backlog intangible asset as a reduction of revenue, resulting in $955
of revenue and no expense each month.
Acquirer records the following journal entries on May 31, 20X9 if the backlog intangible
asset is amortized to expense:
Contract asset
Revenue
Debit
1,005
To recognize revenue on Acquiree's revenue contract for May 20X9
Revenue
20
Accumulated amortization on favorable
contract intangible asset
Credit
1,005
20
To amortize the favorable contract intangible asset to revenue for May 20X9
Amortization expense
Accumulated amortization on backlog
intangible asset
Debit
30
Credit
30
To recognize amortization of backlog intangible asset related to Acquiree's revenue
contract for May 20X9
Acquirer records the following journal entries on June 30, 20X9:
Accounts receivable
Revenue
Contract asset
Contract liability
Debit
3,000
Credit
1,005
1,965
30
To recognize revenue on Acquiree's revenue contract for June 20X9
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17. Determining the Fair Value of Assets Acquired
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Revenue
Accumulated amortization on favorable
contract intangible asset
Debit
20
Credit
20
To amortize the favorable contract intangible asset to revenue for June 20X9
Amortization expense
Accumulated amortization on backlog
intangible asset
Debit
30
Credit
30
To recognize amortization of backlog intangible asset related to Acquiree's revenue
contract for June 20X9
The entries for July through December 20X9 would follow in a similar fashion, with the
contract asset or liability balances being adjusted to account for the difference between
the amounts of revenue and billings, and with amortization of the favorable contract and
backlog intangible assets recognized each period.
ABC separately determines the fair value of the customer relationship intangible asset
and amortizes it to expense over its remaining useful life.
(PRE-ASC TOPIC 842*) OPERATING AND CAPITAL LEASES
17.085 ASC Topic 805 establishes as a general principle that the acquirer classifies or
designates identifiable assets acquired and liabilities assumed on the basis of factors that
exist at the acquisition date. However, ASC paragraph 805-20-25-8 specifies that the
classification of lease contracts as capital or operating is an exception to this general
principle and therefore, the classification of lease contracts by the acquiree at the
inception of the lease is retained in the acquisition accounting. However, lease contracts
are evaluated to determine their fair value at the date of the acquisition.
Operating Leases
17.086 In a business combination, the acquirer would determine whether the terms of
operating lease contracts acquired are favorable or unfavorable relative to market terms
of comparable leases at the acquisition date. The fair value of an operating lease is the
amount another entity of comparable credit standing would pay to assume the lease under
its current terms, or the amount a market participant would pay to exit the lease.
17.087 Quoted market prices, if available, provide the most reliable and best evidence of
fair value. In the absence of active markets with quoted market prices or other reliable
information that indicate the value of the operating lease, the fair value of an operating
lease is estimated using an income approach by identifying the present value of a rent
differential (i.e., the difference between future cash flows under the contractual lease
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terms and current market rental rates). In addition, the original value of an acquired lease
(e.g., the value associated with the avoidance of costs that would normally be incurred to
execute a similar lease) should be considered in determining the fair value of the lease
when the acquiree was the lessor under the operating lease.
17.088 If available, currently obtainable rental rates for similar assets, subject to similar
terms, provide the best estimate of the market rental rate. If information about currently
obtainable rental rates for similar assets is not available, circumstances to consider in
estimating the market rental rate of the asset underlying an acquired operating lease
include, but are not limited to:
• The general availability of the leased asset;
• Characteristics of the counterparty (such as creditworthiness of the lessee);
• The remaining lease term; and
• Renewal provisions and expectations.
17.089 When using the present value of a rent differential to estimate the fair value of an
acquired lease, the acquirer should consider whether the rental rate that could be currently
obtained in a market transaction for the underlying asset is a fair representation of the fair
value rental rate. Some at the money leases, such as operating leases for airport gates, are
sometimes bought or sold in exchange transactions. In those cases, there may be value to
lease even if there is no rent differential.
17.090 The acquirer should consider whether an acquired operating lease may produce
other identifiable intangible assets. For example, in certain real estate leases there may be
an ongoing customer relationship with an anchor tenant associated with an acquired
lease. A customer relationship that meets the recognition requirements of ASC Topic 805
should be recognized separately from the value of the lease and accounted for in a
manner consistent with other separately identifiable intangible assets.
17.091 The present value of a rent differential of an acquired operating lease should be
determined using a discount rate that is commensurate with the risks involved.
Notwithstanding the fact that acquired operating leases may be valued using present
value techniques, it is not appropriate to accrue interest on the value assigned to those
leases subsequent to the acquisition date. Rather, the amount reflected in the acquisition
accounting is amortized as an adjustment to lease expense if the acquiree is a lessee, or
lease income if the acquiree is a lessor in periods subsequent to the acquisition date.
17.092 When lease agreements contain variable terms, such as adjustments based on
revenues or price changes, the acquirer should consider the terms of the lease relative to
current market terms of comparable leases that were consummated near the date of
acquisition to determine the fair value of the lease. If the annual lease payments of an
operating lease are adjusted by the increase in an existing index or rate (such as the
Consumer Price Index) plus 100 basis points, and the current market terms of comparable
leases are based on the increase in the stipulated index plus 250 basis points, the 150
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basis points difference in the application of the inflation index would be considered in
determining the fair value of the lease.
Capital Leases
17.093 An asset under a capital lease acquired in a business combination should be
measured at fair value at the acquisition using the approach in ASC Topic 840, Leases,
that triggered capital lease treatment by the acquiree. If the acquired lease asset was
capitalized by the acquiree because the lease transfers title to the acquiree or contains a
bargain purchase option at the end of the lease term (i.e., under ASC paragraph 840-10-
25-1(a) or (b)), the acquired leased asset often is measured under the cost approach (e.g.,
under the replacement cost new method), similar to the measurement guidance for
Property, Plant, and Equipment in this Section. If the acquired leased asset was
capitalized based on either of the other criteria for classification of leases as capital (i.e.,
under ASC paragraph 840-10-25-1(c) or (d)), the value assigned to the asset underlying
the lease should be the fair value of the right to use the property for the remaining lease
term, which may be estimated by determining the current market rental rates.
17.094 Capital lease obligations assumed in a business combination should be recorded at
the present value of amounts to be paid under the lease agreement using appropriate
current interest rates from the perspective of a market participant.
17.095 The acquirer would not separately recognize an additional asset or liability related
to a favorable or unfavorable contract in a capital lease because the fair value
measurement of the capital lease asset and capital lease obligation would consider all the
terms of the lease contract.
(ASC TOPIC 842) LEASES (ACQUIREE IS LESSEE)
17.095a An acquiree's right of use asset is not measured at fair value. Rather, it is
measured at an amount equal to the lease liability, adjusted for favorable or unfavorable
terms. The favorable or unfavorable component is measured in the same manner
described in Paragraphs 17.086-17.092. For additional guidance on recognizing and
measuring assets and liabilities associated with acquired leases after adopting ASC Topic
842, see chapter 11 of KPMG Handbook, Leases.
(ASC TOPIC 842) LEASES (ACQUIREE IS LESSOR)
17.095b An acquirer recognizes an asset (liability) for favorable (unfavorable) terms in
an acquiree lessor's operating lease. The favorable (unfavorable) asset (liability) is
measured in the same manner described in Paragraphs 17.086-17.092.
17.095c For an acquiree lessor's sales-type and direct financing leases, the lease
receivable is measured at the present value of the remaining lease payments and
guaranteed residual value, and the unguaranteed residual asset is measured as the
difference between the fair value of the underlying asset and the lease receivable. For
additional guidance on recognizing and measuring assets and liabilities associated with
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acquired leases after adopting ASC Topic 842, see chapter 11 of KPMG Handbook,
Leases.
(BEFORE AND AFTER ADOPTING ASC TOPIC 842*) INCOME PRODUCING REAL
ESTATE IN THE REAL ESTATE INDUSTRY
17.096 Acquired income producing real estate should be valued as if the acquired
property were vacant and include the value of used tenant improvements. The following
discussion is intended to provide general guidance on applying this approach for real
estate acquisitions. The identification, valuation, and amortization of tangible and
intangible assets are determined based on the facts and circumstances of each acquisition
and the process may vary from the approach described herein.
Step 1: Determine the as-if vacant fair value of the physical property acquired.
Factors to consider in arriving at the value of a vacant building include current
market lease terms, absorption rates, availability of comparable competing space,
lease commissions and tenant improvements that would be incurred, historical
occupancy and leasing history, quality of the building and its replacement value,
and the future cash flows and valuation assumptions (including the capitalization
rate and risk adjusted discount rate). Consideration should be given to existing
tenant improvements in place in assessing how much, if any, tenant improvement
allowance is needed to execute current market leases. In some cases the client
and/or lender may obtain a dark value appraisal, which should be considered as a
means to determine as-if vacant fair value.
Step 1a: Assign the as-if vacant fair value to land, building and improvements,
and equipment based on each component of the asset’s fair value utilizing a cost
segregation study, appraisal, or comparable analysis.
Step 2: Determine the portion of the consideration transferred related to the value
of above and below market in-place leases. Such amounts are determined on a
lease-by-lease basis by computing the net present value of the difference between
(i) the contractual amounts to be paid pursuant to the in-place lease and (ii)
management’s estimate of the fair market lease rate for the corresponding in-place
lease measured over a period equal to the remaining non-cancellable term of the
lease. However, for below market leases with fixed rate renewals, renewal periods
should be included in the calculation of below market in-place lease values. Once
the acquirer has calculated the value of the above and below market in-place
leases, if that value is favorable (asset position) for some leases but unfavorable
(liability position) for others, the acquirer should present the respective asset and
liability amounts gross on its balance sheet as discussed above. Above market
lease values would be amortized to rental income over the remaining non-
cancelable term of those leases. The below market lease values would be
amortized to rental income over the remaining initial lease term plus any fixed-
rate renewal periods, if applicable.
Step 3: Determine the portion of the consideration transferred related to the value
of leases in-place at acquisition. In-place lease value should consider: (i) the value
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17. Determining the Fair Value of Assets Acquired
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associated with avoiding the cost of originating the acquired in-place leases (i.e.,
the market cost to execute a similar lease, including leasing commission, legal,
and other related costs); (ii) the value associated with the avoidance of tenant
reimbursable operating costs estimated to be incurred during the assumed re-
leasing period (i.e., real estate taxes, insurance, and other operating expenses);
(iii) the value associated with lost rental revenue during the assumed re-leasing
period; and (iv) the value associated with avoided tenant improvement costs or
other inducements to secure a tenant lease. The value of in-place leases is
amortized over the period that the in-place leases are expected to contribute to the
future cash flows of the entity, based on entity-specific assumptions. In practice,
this generally is viewed as the remaining term of the respective lease.
Step 4: Determine the unassigned amount by comparing the purchase price of the
property to the sum of the amounts determined in steps 1-3. The unassigned
amount represents a preliminary estimate of the value to be assigned to acquired
customer relationships.
Step 5: After considering alternative valuation techniques, evaluate the
reasonableness of the amount assigned to the value of customer relationships in
Step 4 to ensure that the value is representative of the customer relationships
acquired. When evaluating the reasonableness of the value assigned to customer
relationships, consider the nature and extent of the acquiree’s existing business
relationships with the tenants, growth prospects for developing new business with
the tenants, and expectations of lease renewals. If the amount appears to be
unreasonable, reassess whether all acquired assets assumed have been identified,
recognized, and properly valued.
17.097 The value of the customer relationship intangible asset is amortized over the
remaining initial term plus any renewal periods in the respective leases, but in no event
should the amortization period be longer than the remaining depreciable life of the
building.
Q&A 17.3: Purchase of a Real Estate Development Company
ABC Corp., a real estate development company, was acquired for $1 million. Assets
consist primarily of cash and real estate (land to be developed, projects under
development, and completed projects). In accordance with Topic 805, the acquirer has
measured the identifiable assets acquired and liabilities assumed, except real estate, at
their acquisition-date fair values. For the net of the acquisition-date amounts of the
identifiable assets acquired and liabilities assumed to equal the consideration transferred
(assume no goodwill is involved), real estate is assigned a value of $1.8 million, which is
assumed to be less than fair value.
Q. Is a value of $1.8 million assigned to real estate appropriate (again, assuming no
goodwill is involved)?
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A. No. Under ASC Topic 805, ABC should determine the acquisition-date fair value of
the identifiable assets acquired and liabilities assumed. It would not be appropriate to
value the real estate using a residual or difference method as described in this example.
Fair value of land to be developed should be based on appraised values. Because ABC is
a real estate developer, it may be appropriate for ABC to analogize to valuation of work-
in-process and finished goods inventories in the valuation of projects under development
and completed projects, respectively.
LIABILITIES
OVERVIEW
17.098 ASC Topic 805 requires that liabilities be measured at fair value determined in
accordance with ASC Subtopic 820-10, reflecting the price that would be paid to transfer
the liability in an orderly transaction between market participants at the date of
acquisition. A fair value measurement of the liability should not include an adjustment
related to a restriction that prevents transfer because the restriction is implicitly or
explicitly captured in the other inputs to the fair value measurement (ASC subparagraph
820-10-35-18B). ASC paragraph 820-10-35-16 states that the transfer of a liability
assumes that the liability would remain outstanding and the market participant transferee
would be required to fulfill the obligation. It is further assumed that the liability would
not be settled with the counterparty or otherwise extinguished on the measurement date.
Because the liability to the counterparty is presumed to be transferred rather than settled,
the fair value measurement reflects the credit risk of the reporting entity and
nonperformance risk is assumed to be the same before and after transfer.
17.099 Because liabilities are not typically transferred in active markets, estimating the
fair value at the acquisition date involves the use of judgment. In ASC paragraph 820-10-
35-16, the FASB noted that in the absence of a quoted price in an active market for an
identical or similar liability at the measurement date, which would be unavailable
because liabilities are not exchange-traded as liabilities, an entity should measure the fair
value of the liability as follows:
• Using a valuation technique based on the quoted price of an investment in the
identical liability traded as an asset;
•
•
If the price of an identical liability traded as an asset is not available, use of a
valuation technique that uses other observable inputs such as the quoted prices
for investments in similar liabilities traded as assets; or
If observable inputs are not available, use of another valuation technique
under an income or market approach.
17.100 The following section identifies commonly used ways to measure the acquisition
date fair value of certain liabilities acquired in business combinations.
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17. Determining the Fair Value of Assets Acquired
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TRADE ACCOUNTS AND NOTES PAYABLE
17.101 Trade accounts and notes payable assumed in a business combination are
measured at fair value. Given the lack of observable markets or observable inputs for the
transfer of trade accounts and notes payable, such liabilities are often measured using an
income approach and discounted at the present value of the amounts to be paid, using an
appropriate discount rate reflecting nonperformance risk inherent in the payable, using a
market participant perspective.
17.102 Similar to trade accounts receivable, discounting for trade account payables may
not be necessary when they are to be settled in a short period of time, provided that the
difference between the present values and the gross amounts of the payables is not
significant.
17.103 In September 2008, the VRG noted that some entities recognize components of
working capital, including trade accounts receivable, at the acquiree’s book value
because the differences resulting from current interest rates are deemed to be
insignificant. However, this is a non-GAAP policy and accordingly, entities should
evaluate the potential significance of the policy and be able to support that applying the
non-GAAP policy is immaterial to the entity’s financial statements at the date of
acquisition and in subsequent periods.
DEFERRED REVENUE (PRE-ASC TOPIC 606##)
17.104 The balance sheet of an acquiree immediately prior to the date of acquisition may
include deferred revenue. Deferred revenue is only recognized in a business combination
when a legal obligation is assumed by the acquirer, such as a legal obligation to provide
goods or services to customers. Revenue that was appropriately deferred by the acquiree
may not represent an assumed liability, or the fair value of the assumed liability may be
different from the amount of the deferred revenue on the acquiree’s balance sheet. A
liability related to deferred revenue on the acquiree’s balance sheet may be greater than
its acquisition-date fair value, and the fair value may be zero when no legal obligation
exists at the acquisition date. For example, an acquiree may have delivered all goods or
services under an arrangement with a customer in exchange for a promissory note, but
may have deferred revenue recognized on its balance sheet because collectibility of the
note was not reasonably assured or the arrangement included extended payment terms
resulting in the deferral of revenue. In this circumstance, the deferred revenue does not
represent a legal obligation, and the acquirer would not record an assumed liability in its
acquisition accounting.
17.105 In situations where the deferred revenue does represent a legal obligation at the
acquisition date, as noted above, this amount may be less than the deferred revenue on
the acquiree’s balance sheet because the acquiree’s deferred revenue usually includes
both a fulfillment margin and a selling margin. Because the acquirer’s legal obligation at
the acquisition date is only the fulfillment effort (i.e., the selling effort occurred before
the acquisition date), the fair value of the deferred revenue may be less than the
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acquiree’s recognized amount. The acquisition-date fair value of the liability is often
estimated using the income approach, and occasionally using the market approach.
Market Approach
17.106 It may be possible in some circumstances to obtain evidence from third-party
contractors to determine the amount that would be paid to transfer the liability to a third-
party market participant at the measurement date. When third-party contractor or market
information is used to determine the fair value of deferred revenue, discounting may not
be necessary. It is generally assumed that the effects of discounting are incorporated into
observed market prices. However, the manner in which the acquirer elects to settle the
liability should not change the fair value estimate. That is, the fair value estimate should
be the same whether the acquirer’s intent is to outsource or fulfill the performance effort
internally. While market information, when available, generally provides the most
reliable and best evidence of fair value, it may be difficult to obtain for most legal
obligations.
Income Approach
17.107 The fair value of an assumed liability related to deferred revenue includes the cost
of fulfilling the obligation plus a normal profit margin, all from the perspective of a
market participant.
17.108 The estimated cost of fulfilling the obligation (i.e., fulfillment effort) forms the
foundation of the fair value calculation for deferred revenue. The fulfillment costs
represent those costs that are directly related to fulfilling the legal obligation under the
contract. Direct costs may include an allocable amount of fixed costs associated with the
fulfillment effort if a market participant incurs such costs to fulfill the obligation.
However, total fulfillment costs should not exceed a reasonable cost structure of a third-
party contractor or market participant. Furthermore, costs associated with the selling
activities before the acquisition date would be excluded from the fulfillment effort.
17.109 The fair value determination for deferred revenue also permits a normal profit to
be realized on the fulfillment effort. A normal profit margin should be the amount that a
market participant expects to receive related to the remaining fulfillment effort and
excludes any profit associated with the selling effort or fulfillment effort prior to the
acquisition date.
17.110 When the fair value is estimated using the income approach, the acquirer
evaluates the terms of the obligation and if discounting would be significant, the cost plus
normal profit margin would be discounted to its present value. In addition, the fair value
of deferred revenue is determined on a pretax basis. If the liability is discounted, use of
an appropriate pretax discount rate from the perspective of a market participant is
appropriate.
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17. Determining the Fair Value of Assets Acquired
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Example 17.7: Deferred Revenue
DEF Corp., a technology-based company, entered into a contract to provide
maintenance support for the computer hardware systems of a customer. At the date of
the contract, DEF collected $100 from the customer to provide services for the
following annual period. Approximately three months later, DEF was acquired by ABC
Corp. in a business combination. At the date of acquisition, DEF had $75 of deferred
revenue ($100 × 9/12) recorded in its financial statements related to the maintenance
support contract. ABC expects to incur costs of $50 to perform the maintenance
support services required under the terms of the contract (legal obligation) and
determines that this is representative of the costs that a market participant would incur
as well.
DEF’s normal total profit margin for transactions of this nature (including both margin
on the selling activity and margin on fulfillment effort) historically was 20% of its
actual costs. If ABC outsources the remaining obligation, a third-party contractor
(market participant) would expect a normal profit margin on the actual costs of the
fulfillment effort of 6%.
In its acquisition accounting, ABC should measure the fair value of the legal obligation
related to the fulfillment of the maintenance support services. The obligation would be
measured at $53 ($50 of additional maintenance support services costs plus $3 of
normal profit margin [$50 × 6%]). The margin associated with the selling activities and
fulfillment effort prior to the acquisition date are excluded from the revenue on the
remaining fulfillment effort.
ABC should evaluate whether its measurement of the liability should be on a
discounted or undiscounted basis based on its determination of whether the effect of
discounting is significant.
In determining the cost of the maintenance support, research and development costs
that ABC conducts in relation to the computer hardware system typically would not be
considered direct costs to servicing the contract if ABC is expected to incur these costs
in the ordinary course of business regardless of whether it had the contract with the
customer.
17.111 There may be instances where the acquired revenue arrangement results in a
liability to provide goods or services and the acquisition of a customer-related intangible
asset. The liability recognized for the assumed legal obligation and any related asset
acquired should be recognized separately (i.e., gross) on the balance sheet. For instance,
an acquiree who is the lessor in an operating lease may have established a customer
relationship that meets the recognition requirements for a customer relationship
intangible asset in ASC Topic 805. Likewise, an acquiree who is the lessee of assets may
have established customer relationships through the use of such assets (e.g., through the
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17. Determining the Fair Value of Assets Acquired
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sublease of such assets) that might also meet the recognition requirements for customer
relationship intangible assets of ASC Topic 805.
(Pre-ASC Topic 842*) Deferred Revenue Arising from a Vendor-Financed Leasing
Arrangement
17.112 The balance sheet of an acquiree immediately before acquisition may include
deferred revenue arising from the application of ASC paragraphs 840-20-40-1 through
40-5, 35-4 through 35-5, and 360-10-40-1 through 40-2 related to vendor-leasing
arrangements. ASC Topic 840 requires that the sale of property subject to an operating
lease or sale of property that is leased by or intended to be leased by a third-party
purchaser, be accounted for as a borrowing if the seller or party related to the seller
retains substantial risks of ownership in the leased property (i.e., the sale proceeds are
recorded as an obligation and the related asset is not derecognized). This liability does
not constitute a legal obligation assumed by the acquirer and, therefore, it is not
recognized as a liability of the combined entity. The acquirer may, however, retain some
of the risks of ownership related to the leased asset. Accordingly, the acquirer should
recognize the estimated fair value of the recourse obligation (e.g., the estimated loss
exposure) on the date of acquisition as a liability. In these situations, the leased asset is
not recognized by the acquirer as an asset as part of the business combination.
Deferred Revenue Arising from Postcontract Customer Support (PCS)
Arrangement (Pre-ASC Topic 606##)
17.113 When measuring the fair value of deferred PCS revenue of a software vendor that
exists at the acquisition date, one of the key questions is whether a customer’s right to
receive unspecified upgrades/enhancements on a when-and-if-available basis should be
included in the measurement of the fair value of the legal obligation. This was discussed
by the EITF in Issue 04-11, “Accounting in a Business Combination for Deferred
Postcontract Customer Support Revenue of a Software Vendor;” however, the Task Force
was unable to reach consensus and the Issue was removed from its agenda.
17.114 There are two analyses that are widely used in practice. In the first view, each
component of a PCS arrangement is evaluated separately to assess whether it is a legal
obligation that should be included in the measurement of the fair value of the vendor’s
obligation as of the acquisition date. Under this view, the fair value of the deferred PCS
revenue would be the fair value of the obligation to provide support services and error
corrections (i.e., bug fixes). Because the vendor has no legal obligation to develop and
deliver upgrades/enhancements, the fair value would not include any value attributable to
the when-and-if available enhancements. Although the acquiring entity has an obligation
to deliver upgrades/enhancements if they are subsequently developed, whether or not
development occurs is within the entity’s control. The acquiring entity can, at its
discretion, avoid the use of assets by ceasing development efforts for
upgrades/enhancements.
17.115 Under the second view, a PCS arrangement is one unit of account for purposes of
assessing whether a legal obligation has been assumed. The concept of PCS as a single
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17. Determining the Fair Value of Assets Acquired
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arrangement is consistent with the Codification’s definition of PCS. Under this analysis,
the fair value of the deferred PCS revenue would include the value attributable to the
when-and-if available upgrades/enhancements.
17.116 Under both views, the fair value of the obligation should consider the likelihood
that a market participant would not perform under the terms of the arrangement. We
believe both views are acceptable and the method should be consistently applied as an
accounting policy election.
17.117 In our experience, the obligation under either view is often measured using an
income approach (i.e., cost plus a normal profit margin) as described beginning in
Paragraph 17.107. We believe that the use of a bottom-up analysis (i.e., a cost build-up
analysis) would be appropriate under either view. A top-down analysis (i.e., estimated
selling price less estimated selling costs and related margin) also may be an appropriate
analysis for estimating the fair value of deferred revenue. Either is likely to result in
substantially less deferred revenue than recorded by the seller pre-acquisition.
LONG-TERM DEBT
17.118 Long-term debt, such as bonds and interest-bearing notes, are financial
obligations that are not payable within 12 months. In a business combination, debt
assumed is required to be measured at fair value at the date of acquisition. Quoted market
prices, if available, generally provide the most reliable and best evidence of fair value.
The use of quoted market prices for the debt traded as an identical asset can be used to
measure fair value.
17.119 In the absence of quoted market prices for debt assumed (e.g., privately issued
debt, quoted price of the instrument when traded as an asset), fair value is frequently
determined using a market approach or income approach or, if appropriate, an entry price
as a proxy for of the exit price of the liability (see Paragraph 16.040).
17.119a Debt issuance costs of the acquiree for debt issued prior to the business
combination are generally recorded by the acquiree as a reduction of the liability and
amortized over the debt term. Unamortized debt issuance costs of the acquiree are not
recognized in a business combination because they do not meet the definition of an asset.
Furthermore, debt issuance costs are not factored into the fair value measurement of the
debt.
Market Approach
17.120 If quoted market prices are not available, an acquirer’s best estimate of fair value
may be based on the quoted market price of debt instruments traded as assets with similar
characteristics, for example, quoted market prices of a similar debt instrument that is
traded as an asset on a public exchange or dealer market, taking into consideration legal
restrictions on the debt obligation. Similar market approaches are available when
determining the fair value of debt assumed in a business combination, including a matrix
pricing technique. Matrix pricing is a mathematical technique used to value debt
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17. Determining the Fair Value of Assets Acquired
and Liabilities Assumed in a Business Combination
securities without relying exclusively on quoted prices for the specific securities, but
rather by relying on the securities' relationship to other benchmark quoted securities.
Income Approach
17.121 An acquirer’s best estimate of the fair value of the debt obligation may be based
on the present value of current market expectations of future cash flows using an
appropriate discount rate. An appropriate discount rate is developed using observable
inputs, if available, and should reflect current interest rates, credit assumptions, market
liquidity, and other factors that market participants would incorporate in determining the
price they expect to receive for the liability to be transferred to them.
17.122 The discount rate should be based on the credit standing of the combined entity if
the acquirer becomes directly obligated or guarantees the assumed debt. The credit
standing of the combined entity may have characteristics of the creditworthiness of the
acquirer prior to the business combination, or a blended credit standing of the acquirer
and acquiree (e.g., for publicly traded debt, the market may react negatively to the
increased leverage and combined credit profile of the acquirer as a result of the business
combination). If the debt remains the obligation of the acquiree only, the appropriate
discount rate may be the rate applicable to the acquiree’s stand-alone creditworthiness at
the date of acquisition. However, if market participants anticipate that the acquiree will
benefit from synergies of the combined entity, then a more favorable discount rate may
be appropriate. We believe using the acquirer's discount rate indicates that the acquirer
has implicitly guaranteed the debt, whereas using the acquiree's discount rate could imply
that the acquirer would tolerate a default scenario. For a strategic acquirer, we believe
that using the acquiree's discount rate would be rare, because usually the acquirer would
not permit debt default, which could lead to deconsolidating the subsidiary if it goes into
bankruptcy and effectively negate the purpose of an acquisition. However, for a financial
acquirer (e.g., a private equity firm), using the acquiree's discount rate might be more
appropriate.
17.123 Factors to consider in determining the fair value of the debt assumed include:
a. The remaining term to maturity of the debt assumed. If the debt assumed has a
remaining term to maturity of five years, the market interest rate of the new
debt with a five-year term to maturity should be considered in determining the
appropriate interest rate to use in determining fair value.
b. Conversion features of the debt, if any. If the debt is convertible into preferred
or common stock, the market price of the preferred or common stock into
which the debt is convertible should be considered in determining fair value.
c. All other terms of the debt instrument, such as prepayment penalties, change-
in-control provisions, call provisions, guarantees, and debt covenants.
d. If the interest rate on the debt assumed in a business combination is dependent
on the prime rate or another benchmark rate, but subject to a stated minimum
and maximum rate condition at the date of acquisition.
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17. Determining the Fair Value of Assets Acquired
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Example 17.8: Determining the Fair Value of Debt Assumed in a Business
Combination
ABC Corp. acquires DEF Corp. in a business combination. DEF operates in a newly
deregulated industry, experienced operating losses, and expects negative cash flows
beginning two years from now. ABC has an AA-credit rating and can borrow at 5%,
while DEF has a BBB-credit rating and can borrow at 12%. Before the business
combination, DEF’s property, plant, and equipment were financed with senior unsecured
debt. ABC intends to assume or guarantee the debt as part of the business combination.
There are no prepayment rights as part of the debt obligation.
Q. In determining the fair value of the debt assumed, how should ABC evaluate the
senior unsecured debt?
A. Because ABC intends to assume or guarantee the senior unsecured debt, the debt
should be evaluated based on the creditworthiness of the combined entity (e.g., if the debt
is publicly traded, market participants may anticipate the enhanced credit standing of the
debt at the date of acquisition based on the creditworthiness of the combined entity when
pricing the debt).
However, if the debt remains the obligation of the acquiree, the effective interest rate
would be based on the prior credit characteristics of the debt obligation based on DEF’s
BBB-credit standing if market participants expect that ABC will not guarantee the debt.
The fair value of the debt may be higher or lower than its face value resulting in the
recognition of a debt premium or discount, and an effective interest rate that is lower or
greater than the contractual rate.
17.124 In periods after the acquisition, the acquirer should amortize the difference
between the fair value recorded on the acquisition date and the ultimate settlement
amount using the interest method. If the interest rate used in the valuation of the debt
assumed in a business combination is higher than the stated rate of the debt, a discount on
debt should be recognized and amortized of the remaining period to maturity using the
interest method. Similarly, if the interest rate used in the valuation of debt assumed in a
business combination is lower than the stated rate on the debt, a premium on the debt
should be recognized and amortized over the remaining period to maturity using the
interest method. The recognition of a discount or premium on debt for financing reporting
purposes may result in a deductible or taxable temporary difference under ASC Topic
740, unless the discount or premium on debt also is recognized for income tax reporting
purposes.
ASSET RETIREMENT OBLIGATION
17.125 If a long-lived asset with an existing asset retirement obligation is acquired in a
business combination, the acquirer should recognize the acquisition-date fair value of the
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17. Determining the Fair Value of Assets Acquired
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obligation in accordance with ASC Subtopic 410-20, Asset Retirement and
Environmental Obligations - Asset Retirement Obligations. The long-lived asset is valued
on an unencumbered basis (i.e., without regard to the asset retirement obligation), and the
related asset retirement obligation is recognized and measured separately. ASC Subtopic
410-20 applies to legal obligations associated with the retirement of tangible long-lived
assets that result from the acquisition, construction, or development and (or) the normal
operation of a long-lived asset, except for certain obligations of lessees. ASC paragraphs
410-20-15-1 through 15-3
17.126 In determining the fair value of an asset retirement obligation, quoted market
prices, if available, provide the most reliable and best evidence of fair value. In the
absence of quoted market prices for the obligation, fair value is often determined using an
income approach. ASC Subtopic 410-20 states that an expected present value technique
will usually be the appropriate technique with which to estimate the fair value of a
liability for an asset retirement obligation.
DERIVATIVE INSTRUMENTS
17.127 In a business combination, the values assigned to derivative instruments, such as
options and interest rate swaps, under ASC Topic 815, Derivatives and Hedging, should
be based on the fair value of the instruments at the date of acquisition. The fair value of
derivative assets should consider the effect of potential nonperformance of the derivative
counterparty. In addition, ASC Subtopic 820-10 requires that the fair value of liabilities,
including derivatives, also consider the impact of the entity’s own nonperformance risk.
Many derivative instruments (e.g., swaps and forwards) are affected by the risk of
nonperformance of both the counterparty and the entity because the derivatives can be
liabilities at some time during their lives and assets at other times (depending on market
movements). For these derivatives, both the risk of counterparty credit risk and an
entity’s own nonperformance risk would be considered by a market participant in
determining the fair value of these instruments regardless of whether they are currently in
an asset or liability position.
REDEEMABLE PREFERRED STOCK
17.128 Although redeemable preferred stock may not meet the definition of a liability, it
does represent a potential commitment to make future payments, and the acquirer should
record the commitment at its fair value at the acquisition date.
Example 17.9: Redeemable Preferred Stock Held by Noncontrolling
Interests
Q. How should an acquirer determine the fair value of redeemable preferred stock (RPS)
that is held by noncontrolling interests?
A. A market approach or income approach is used most often to determine fair value of
RPS. Under a market approach, quoted market prices, if available, are the best evidence
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17. Determining the Fair Value of Assets Acquired
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of fair value. Where quoted market prices for the RPS are not available, the acquirer can
use the income approach and estimate fair value as the present value of amounts to be
paid using an appropriate discount rate. Where the acquirer does not collateralize or
guarantee the RPS, the appropriate discount rate would be the rate that applies to the
acquiree on a stand-alone basis if that is consistent with market participant assumptions.
Qualified independent investment bankers may be needed to estimate the discount rate.
* ASU 2016-02, Leases, changes certain aspects of accounting for leases acquired in a business
combination. The ASU is effective for public business entities, certain not-for-profit entities, and certain
employee benefit plans for annual and interim periods in fiscal years beginning after December 15, 2018.
For not-for-profit entities that have issued or are conduit bond obligors for securities that are traded, listed,
or quoted on an exchange or an over-the-counter market that have not yet issued financial statements or
made financial statements available for issuance as of June 3, 2020, it is effective for annual and interim
periods in fiscal years beginning after December 15, 2019. For all other entities, the ASU is effective for
annual periods in fiscal years beginning after December 15, 2021, and interim periods in fiscal years
beginning after December 15, 2022. Early adoption is permitted.
# The completed contract and percentage of completion methods are eliminated by ASC Topic 606,
Revenue from Contracts with Customers, which is effective for public business entities for interim and
annual periods in fiscal years beginning after December 15, 2017. For all other entities (nonpublic entities)
that have not yet issued financial statements or made financial statements available for issuance as of June
3, 2020, the amendments in this ASU are effective for annual periods in fiscal years beginning after
December 15, 2019, and interim periods in fiscal years beginning after December 15, 2020. All other
entities may apply ASU 2014-09 earlier for annual and interim periods in fiscal years beginning after
December 15, 2016. All other entities also may apply ASU 2014-09 earlier as of an annual period in fiscal
years beginning after December 15, 2016, and interim periods in fiscal years beginning one year after the
annual period in which the entity first applies ASU 2014-09.
## FASB ASC Topic 606, Revenue from Contracts with Customers, changes the accounting for revenue
from contracts with customers and establishes the definition of contract assets and contract liabilities. ASC
Topic 606 is effective for public business entities and not-for-profit entities that are conduit bond obligators
for annual periods commencing on or after December 16, 2017. For all other entities (nonpublic entities)
that have not yet issued financial statements or made financial statements available for issuance as of June
3, 2020, the amendments in this ASU are effective for annual periods in fiscal years beginning after
December 15, 2019, and interim periods in fiscal years beginning after December 15, 2020. All other
entities may apply ASU 2014-09 earlier for annual and interim periods in fiscal years beginning after
December 15, 2016. All other entities also may apply ASU 2014-09 earlier as of an annual period in fiscal
years beginning after December 15, 2016, and interim periods in fiscal years beginning one year after the
annual period in which the entity first applies ASU 2014-09.
1 The gross amount (before reserve) represents the FIFO value.
2 Deducting holding costs is explicitly mentioned in the guidance for tax purposes but was omitted in the
historical (now superseded) guidance that was present in Statement 141. However, holding costs may have
been considered as a component of costs of disposal. In any case, if inventory turnover rates are high, the
opportunity cost of holding inventory is likely to be de minimis.
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Section 18 - Determining the Fair Value of
the Consideration Transferred in a
Business Combination
Detailed Contents
Fair Value of the Consideration Transferred
Overview
Consideration in the Form of Equity Interests
Valuation Analysis
Shares of a Subsidiary Issued in a Business Combination
Issuing Shares of a Nonpublic or Closely Held Entity
Preferred Shares Issued in a Business Combination
Share-Based Payment Awards Included in the Consideration Transferred
(Replacement Awards)
Debt Issued to Former Owners of Acquiree
Contingent Consideration
Example 18.1: Determining the Fair Value of Liability-Classified Contingent
Consideration--Scenario 1
Example 18.2: Determining the Fair Value of Liability-Classified Contingent
Consideration—Scenario 2
Example 18.3: Determining the Fair Value of Liability-Classified Contingent
Consideration--Scenario 3
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18. Determining the Fair Value of the Consideration Transferred
in a Business Combination
FAIR VALUE OF THE CONSIDERATION TRANSFERRED
OVERVIEW
18.000 As discussed in Section 6, Recognizing and Measuring the Consideration
Transferred, consideration transferred in a business combination may be in many forms
including, for example, cash, noncash assets (e.g., a business or a subsidiary), debt issued
to the former owners of the acquiree, equity interests issued (e.g., common or preferred
equity instruments, options, warrants, member interests of mutual entities), replacement
share-based payment awards, and contingent consideration. All consideration transferred,
with the exception of replacement share-based payment awards, is measured at fair value
at the acquisition date. Replacement share-based payment awards are measured in
accordance with the fair value-based measurement principles of ASC Topic 718,
Compensation—Stock Compensation.
18.001 Cash payments by an acquirer do not present measurement difficulties. However,
the measurement of other forms of consideration can present varying degrees of difficulty
and require judgment, so that it may be helpful to have an independent valuation
performed in some situations. This Section includes discussion of certain elements of the
consideration transferred in a business combination and the related measurement
approaches for determining the fair value of those specific items. See Section 6 for
additional accounting guidance related to the recognition and measurement of
consideration transferred in a business combination.
CONSIDERATION IN THE FORM OF EQUITY INTERESTS
18.002 Equity interests issued as consideration in a business combination (other than
replacement share-based payment awards) are measured at fair value at the acquisition
date. Whenever available, the quoted price in an active market should be used to measure
the fair value of equity securities issued to effect a business combination. If a quoted
price in an active market is not available, other approaches will be needed.
Valuation Analysis
18.003 An AICPA Task Force developed a Practice Aid, Accounting and Valuation
Guidance: Valuation of Privately-Held-Company Equity Securities Issued as
Compensation, about valuing private entities. The Practice Aid was issued in 2013 to
provide measurement guidance to be considered when valuing equity instruments of
privately held entities. Although the Practice Aid is not authoritative, its guidance has
been used as a resource by preparers, valuation professionals, and auditors in all
industries.
18.004 While business combinations are outside its scope, the Practice Aid may contain
some useful information (e.g., valuation techniques and best practices relevant to such
valuations). Furthermore, Table 5-1 of the Practice Aid details some key differences
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18. Determining the Fair Value of the Consideration Transferred
in a Business Combination
between the valuations of a controlling interest versus a noncontrolling interest in an
entity.
18.005 Paragraph not used.
18.006 The Practice Aid provides specific guidance and reporting requirements on
valuations for financial reporting purposes. Key issues to consider when valuing equity
securities of privately held entities include:
• Fair Value Hierarchy. The Practice Aid states that a valuation performed for
the purpose of valuing privately held common stock issued as compensation
should be based on the definition of fair value used in the employee share-
based payment Topic (ASC Topic 718) and nonemployee share-based
payment Subtopic (ASC Subtopic 505-50). This definition is different from
the definition of fair value in ASC Subtopic 820-10 and is described in ASC
Topic 805 as a fair value-based measure. Consistent with ASC Subtopic 820-
10, the Practice Aid indicates that quoted prices in active markets are the best
evidence of fair value. While quoted prices are not available for private
entities, an entity may have had recent cash transactions for the issuance of
shares that can be used to value a security. Use of such transactions would be
contingent on (1) the transaction being for the same or similar shares as those
being valued, and (2) the transaction being a current transaction between
willing parties, that is, other than on a forced or liquidation basis, and not
arising from the terms of a prior transaction (e.g., tranched equity offerings,
the strike price of exercised share options would not be regarded as indicative
of the fair value of the underlying shares or an investment by a strategic
investor may not be representative of fair value for other shares).
• Hierarchy of Valuation Alternatives. The Practice Aid states that the
reliability of a valuation report depends on the timing of the valuation
(contemporaneous or retrospective) and the objectivity of the valuation
professional (unrelated or related). It recommends that an entity engage an
unrelated valuation professional to assist management in determining fair
value if neither quoted prices in active markets nor arm’s-length cash
transactions are available. The Practice Aid further states that for purposes of
valuing privately issued securities for which observable market prices of
identical or similar securities are not available, the most reliable fair value
estimate would be produced by a contemporaneous valuation.
• Rules of Thumb Are Inappropriate. An entity should not apply rules of
thumb to value equity shares. For example, rules of thumb that value common
shares at a specified discount to a recent round of financing with preferred
shares or at a discount to an expected IPO price would be inappropriate.
• Valuation of the Enterprise. In valuing equity shares of privately held
entities, the Practice Aid suggests a top-down analysis, whereby the value of
the enterprise is determined and is allocated to debt and the different classes
of equity.
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When valuing shares of privately held entities, generally the value of the
entity as a whole should be established, and then used to value each class of
the entity’s outstanding shares. This top-down analysis should be based on an
evaluation of the different rights of each class of shares, including their
liquidation, redemption, or conversion rights. The Practice Aid includes
extensive discussion on the nature of these rights.
• Valuation Analyses to Establish Enterprise Value. Absent quoted prices or
comparable cash transactions, other valuation approaches must be applied to
value shares issued by privately held entities. These include the income,
market, or cost approaches. The selection of approach(es) depends, in part, on
the nature of the entity and its stage of development.
•
In applying an income approach, the Practice Aid indicates that either a
discount rate adjustment technique or an expected cash flow technique
may be applied. Interest rates used under the traditional present value
technique are usually significantly higher than those of similar public
entities, calculated using the traditional Capital Asset Pricing Model.
• When applying a market approach, consideration should be given to the
comparability of the entities used in the market analysis and an
understanding that the comparable transactions were on a fair value
premise (e.g., not a forced sale) for like shares. Comparable pricing
information may not be available for early stage entities. The Practice Aid
discusses the use of the backsolve method, whereby transactions involving
the entity’s own securities are used to solve for the implied aggregate
equity value of the entity.
• A cost (asset-based) approach is generally less conceptually sound for
valuing shares of privately held entities. However, an asset-based
approach may be acceptable at an early stage of an entity’s development
when it is difficult to apply a market or income approach.
• Valuation Analyses to Assign Enterprise Value to Different Classes of
Equity. The Practice Aid discusses several possible methods of assigning
enterprise value to an entity’s underlying shares. It refers to these methods as
the Current-Value Method, the Option-Pricing Method, the Probability-
Weighted Expected Return Method, and the Hybrid Method, and discusses
circumstances when each method would be more or less appropriate and
provides examples.
• The Current-Value Method assigns value to preferred shares based on
its current liquidation or immediate conversion values, whichever is
greater. The Practice Aid states that a disadvantage of this method is that
while it may be easier to understand, it is highly sensitive to the
underlying assumptions. It also looks at the current best value for the
preferred shares, without regard to possible future price movements. An
entity should take care in using the current-value method because this
method may undervalue the common shares when there is no plan to
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liquidate or sell the entity in the near future, because the common shares
frequently derive much of their value from their disproportionate share of
the future market value. This occurs frequently for entities emerging from
bankruptcy, early-stage entities, and entities financed by private equity
investors.
• The Option-Pricing Method treats the common and preferred shares as
options on the entity’s enterprise value. The Practice Aid states that a
disadvantage of this method is that it may be complex to implement and
that some of the assumptions to which it is highly sensitive, for example,
the volatility or term, are difficult to objectively estimate. However, this
method does capture the option-like characteristics of common shares for
entities whose common shares are a small portion of the total capital
structure.
• The Probability-Weighted Expected Return Method estimates the
value of the common and preferred shares by considering possible
scenarios for future enterprise value and realization of return by
shareholders (e.g., IPO, sale to a strategic buyer, leveraged
recapitalization, and continued operation). The return to the preferred and
common shareholders is estimated under each scenario, as are associated
probabilities. The Practice Aid acknowledges that this technique is
difficult to implement and requires a number of assumptions about
possible future outcomes, which are difficult to objectively estimate. This
method is most appropriate when the time to a liquidity event is short.
• Hybrid Methods are discussed in the Practice Aid. In some situations, it
may be appropriate to include a combination of the OPM and PWERM
methods. The advantage of using both methods is that option-like payoffs
associated with the various share classes are captured, while also
considering future payoff scenarios.
• Marketability Discounts. Marketability discounts are often appropriate when
valuing shares of privately held entities. The level of such discounts should be
based on an evaluation of the shares’ specific facts and circumstances (e.g.,
prospects for liquidity, restrictions on transferability, size, and timing of
distributions). The use of rules of thumb or of average or median discounts
reported in restricted shares studies is not appropriate.
• Pre-IPO and IPO Value. The Practice Aid acknowledges that differences
would exist between pre-IPO and post-IPO values. The Practice Aid states
that an IPO value eliminates many of the factors that give rise to a lack-of-
marketability discount, by providing liquidity, reducing valuation
uncertainties, and reducing ownership concentration.
The Practice Aid indicates that significant differences between pre- and post-
IPO values can exist. A valuation professional often accounts for the lack of
marketability before an IPO by applying a marketability discount against the
results of the valuation techniques (i.e., under the income, market, or asset-
based approaches). Some of the difference in value between private and public
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entities may also be reflected in the discount rate used in the income approach.
The Practice Aid indicates that the cost of capital for public entities may be
lower, which would cause them to have a higher value than an otherwise
comparable privately held entity. The quantification of such differences must
be evaluated on a case-by-case basis, based on an entity’s specific facts and
circumstances.
• Contents of a Valuation Report. The Practice Aid includes detailed
suggestions for the contents of a valuation report. It indicates that a valuation
report prepared by a related valuation professional, including an internal
report prepared by management, should contain the same level of information
as that prepared by an external valuation professional.
Summary reports are acceptable if issued as updates to a comprehensive
report issued within the last year, when there has been no significant event or
major financing that has occurred or is expected to occur.
Shares of a Subsidiary Issued in a Business Combination
18.007 Shares of a subsidiary issued in a business combination in exchange for shares of
the acquiree should be valued as of the acquisition date based on the principles discussed
in the previous paragraph. If the acquirer continues to maintain a controlling financial
interest in the subsidiary after issuance, any difference between the fair value of the
subsidiary shares issued and the carrying amount of the acquirer’s respective interest in
the subsidiary’s net assets will be recognized as a capital transaction in equity in
accordance with the noncontrolling interests guidance of ASC Subtopic 810-10,
Consolidation - Overall. See Chapter 7 of KPMG Handbook, Consolidation, for
additional guidance related to the accounting for noncontrolling interests.
Issuing Shares of a Nonpublic or Closely Held Entity
18.008 The acquisition of a public entity by a privately held entity provides an example
of where the acquisition-date fair value of an acquiree’s equity interests may be more
reliably measurable than the acquisition-date fair value of the acquirer’s equity interests
issued to effect a business combination. In those situations, consideration should be given
to the fair value of the acquiree’s equity interests in determining the fair value of the
shares issued to effect the combination.
Preferred Shares Issued in a Business Combination
18.009 When preferred shares are issued in a business combination to the shareholders of
the acquiree and there is no quoted market price available to determine the fair value of
those shares, the characteristics of the preferred shares (e.g., dividend rate, conversion
features, or redemption features) should be incorporated into the fair value of the
preferred shares. For example, the fair value of nonvoting, nonconvertible preferred
shares that lack characteristics of common shares may be determined by comparing the
specified dividend and redemption terms with those of comparable securities and by
assessing market factors. The approach to determining the fair value of such shares may
be similar to that used to determine the fair value of debt securities.
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18.010 The Practice Aid for privately held entities provides guidance and other
considerations for determining the fair value of preferred shares. The guidance may be
useful in measuring the fair value of preferred shares as part of the consideration
transferred in a business combination.
18.011 See Section 6 for accounting guidance and other fair value consideration related
to convertible preferred shares and other convertible instruments issued in a business
combination.
Share-Based Payment Awards Included in the Consideration Transferred
(Replacement Awards)
18.012 An acquirer may exchange its share-based payment awards (replacement awards)
for awards held by grantees of the acquiree. If the acquirer is obligated to replace the
awards, either all or a portion of the acquirer’s replacement awards must be included in
measuring the consideration transferred in a business combination. The measurement of
replacement awards is a fair-value-based measure under ASC Topic 718, and is an
exception to a fair value measurement principle under ASC Topic 805, Business
Combinations.
18.013 See discussion of Acquirer Share-Based Payment Awards Exchanged for Awards
Held by the Grantees of the Acquiree in Section 11.
Debt Issued to Former Owners of Acquiree
18.014 An acquirer may issue debt to the former owners of the acquiree as part of the
consideration transferred in a business combination. Quoted market prices, if available,
generally provide the best evidence of fair value. In the absence of quoted market prices
for the debt instrument (e.g., privately issued debt), fair value is frequently determined
using a market approach or income approach.
Market Approach
18.015 If quoted market prices for an identical or similar liability are not available, an
acquirer’s best estimate of fair value may be based on the quoted market price of
identical debt instruments traded as assets in active markets; for example, a quoted
market price of an identical debt instrument traded as an asset on a public exchange or
dealer market. If that price is not available, other observable inputs may be used, such as
the quoted price in a market that is not active for the identical item held by another party
as an asset. If prices for an identical liability traded as an asset are not available, there are
other similar market approaches available when determining the fair value of the debt
instrument, including a matrix pricing technique.
Income Approach
18.016 An income approach measures the fair value of the debt instrument as the present
value of the expected future cash flows using an appropriate discount rate. The discount
rate should reflect what a market participant would demand to assume the risks of that
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liability including general interest rates, credit assumptions of the acquirer or combined
entity depending on the facts and circumstances, market liquidity, and other risk factors.
For examples of valuation techniques used under a market or income approach, see
chapter F of KPMG Fair Value Measurements - Questions and Answers.
Contingent Consideration
18.017 Contingent consideration includes, but is not limited to obligations to transfer
additional consideration to the former owners of the acquiree if specified future events
occur or conditions are met. Contingent consideration may include the issuance of
additional securities or distribution of other consideration (e.g., cash) on resolution of
contingencies based on, for example, postcombination earnings, postcombination security
prices, regulatory approvals or other factors. All contingent consideration is measured at
fair value on the acquisition date and included in the consideration transferred.
18.018 Contingent consideration issued in a business combination is classified at the
acquisition date as either equity, or as an asset or a liability, based on the applicable
GAAP. The accounting for contingent consideration after the transaction depends on
whether the obligation for contingent consideration is classified as equity or as a liability
(or in some cases, as an asset). See discussion of Contingent Consideration in Sections 6
and 12 for accounting guidance related to the classification and subsequent accounting,
respectively, for contingent consideration.
18.019 Regardless of classification, estimating the fair value of contingent consideration
can be challenging as the arrangements are often complex. ASC Subtopic 820-10
provides guidance for fair value measurements used in financial reporting, including
contingent consideration. The guidance specifies that in cases where there is no quoted
price for a liability or equity, an entity shall measure the fair value of the liability or
equity instrument from the perspective of a market participant that holds the identical
item as an asset. An entity should first consider observable market prices to measure the
fair value of the identical item held by other parties as an asset. When observable prices
are not available, an entity generally will apply an income approach or market approach
from the perspective of the market participant holding the identical item as an asset.
ASC Paragraph 820-10-35-16B
When a quoted price for the transfer of an identical or a similar liability or
instrument classified in a reporting entity’s shareholders’ equity is not available
and the identical item is held by another party as an asset, a reporting entity shall
measure the fair value of the liability or equity instrument from the perspective of
a market participant that holds the identical item as an asset at the measurement
date.
ASC Paragraph 820-10-35-16BB
In such cases, a reporting entity shall measure the fair value of the liability or
equity instrument as follows:
a. Using the quoted price in an active market for the identical item held by
another party as an asset, if that price is available
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b. If that price is not available, using other observable inputs, such as the
quoted price in a market that is not active for the identical item held by
another party as an asset
c. If the observable prices in (a) and (b) are not available, using another
valuation approach, such as:
1. An income approach (for example, a present value technique that takes
into account the future cash flows that a market participant would expect
to receive from holding the liability or equity instrument as an asset; see
[ASC] paragraph 820-10-55-3F).
2. A market approach (for example, using quoted prices for similar
liabilities or instruments classified in shareholders’ equity held by other
parties as assets; see [ASC] paragraph 820-10-55-3A).
18.019a The income approach is generally appropriate for measuring the fair value of
contingent consideration, given the forward-looking characteristics of contingent
consideration arrangements and the lack of similarly traded assets or liabilities. There are
two methodologies under the income approach to consider when determining the fair
value of contingent consideration:
• Scenario Based Method: Similar to the Expected Present Value Technique
(as discussed in ASC paragraphs 820-10-55-13 through 55-20), the Scenario
Based Method (SBM) considers a range of potential outcomes and their
assigned probabilities of occurrence. The expected cash flows attributable to
contingent consideration are the sum of the probability-weighted outcomes for
each of the scenarios. The outcomes are discounted to present value at an
appropriate risk-adjusted discount rate.
• Option Pricing Method: An option pricing method (OPM), such as a risk-
neutral Monte Carlo simulation, lattice model, or Black-Scholes-Merton
option pricing model incorporate present value techniques and reflect both the
time value and the intrinsic value of an option.
18.019b When determining whether a SBM or OPM is appropriate for contingent
consideration one should consider whether:
• The goal is to incentivize the earnout recipients to significantly outperform
baseline target metrics after the acquisition, or it is akin to a deferral of
payment with easy-to-achieve target metrics (i.e., is the target metric
substantive). See Example 18.3 for further details.
It is based on contingencies that are systematic (nondiversifiable risk)1 or
unsystematic (diversifiable risk)2 or both.
•
• The payoff structure is linear or non-linear.
• A linear payoff occurs when the contingent consideration payoff is a fixed
percentage of the underlying metric (e.g., the contingent consideration
payoff is 50% of revenue over the first three years after the acquisition).
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• A non-linear payoff occurs when the contingent consideration payoff is
defined as a non-linear function on the underlying metric – frequently
involving thresholds, caps, tiers, or catch-up features (e.g., if revenue is
less than $2 million, the contingent consideration payoff is zero; however,
if revenue is at least $2 million but not greater than $5 million, the
contingent consideration payoff is 50% of the revenue in excess of $2
million, and if revenue is greater than $5 million, the contingent
consideration payoff is $2.5 million plus 75% of the revenue in excess of
$5 million).
• The payoff in one period is dependent on the payoff in an earlier period (i.e.,
path-dependent).
18.020 Considering the factors above, an SBM is well suited for (1) systematic financial-
based metrics that are linear in nature and (2) unsystematic metrics such as technical
milestones (e.g., based on FDA approval). In contrast, an OPM is well suited for non-
linear payoffs based on systematic metrics/outcomes, which is similar to the structure of
an option payment. However, an SBM would likely still be appropriate for a non-linear
payoff when the target metric is not substantive because the threshold is so low that the
payoff is approximately linear at the measurement date (see Example 18.3 for further
details).
18.020a If the non-linear payoff is path dependent, a more complex simulation based
OPM (e.g., Monte Carlo simulation) is generally used. Other OPMs (e.g., Black-Scholes-
Merton) may be suitable when the payout is based on a single period or not dependent on
the prior period.
18.020b Regardless of which method is selected the valuation should consider:
• The estimated expected future cash flows of the contingent consideration,
which in the case of non-linear structures requires an understanding of the
probability distribution of potential outcomes for the underlying metric; and
• A discount rate that reflects the risk inherent in the expected future cash flows
of the contingent consideration. In general, the discount rate estimate should
include allowances for:
• The time value of money (risk-free rate);
• The systematic risk inherent in the underlying metric or outcome;
• The impact of the structure of the contingent consideration on the risk of
the expected cash flows3; and
• Counterparty credit risk associated with the ability to make the future
payments.
18.021 – 18.022 Paragraphs not used.
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Example 18.1: Determining the Fair Value of Liability-Classified Contingent
Consideration--Scenario 1
On January 1, 20X9, ABC Corp. acquires DEF Corp. in a business combination for $100
million. As part of the business combination, ABC and DEF’s former owners enter into a
contingent consideration arrangement. ABC agrees to pay additional cash consideration
equal to 5% of the total revenue generated by DEF between the acquisition date and the
first anniversary of the acquisition. According to DEF’s most recent forecast, which
reflects market participant expectations, revenue for the first year following the
acquisition is projected as follows: a 60% probability of $125 million, a 20% probability
of $100 million, and a 20% probability of $140 million.
In determining the fair value of the contingent consideration, ABC considers the expected
revenue amounts and their associated probabilities1, resulting in an expected payment of
$6.15 million [($125 × 60% + $100 × 20% + $140 × 20%) * 5%]. Because ABC expects
the payment one year from the acquisition date, it calculates the present value of the
contingent consideration using an appropriate discount rate, which would not be a risk-
free rate because the $6.15 million is not a certainty-equivalent amount, and the amount
is included in the acquisition-date fair value of the consideration transferred. The
contingency is liability-classified because it requires cash settlement and, as such, ABC
must remeasure it to fair value each reporting period until the contingency is settled.
ABC recognizes adjustments resulting from remeasurement in current earnings.
1This technique is known as the Expected Value Method and is described in ASC Section 820-10-55.
Example 18.2: Determining the Fair Value of Liability-Classified Contingent
Consideration—Scenario 2
As part of a business combination on January 1, 20X7, ABC Corp. agrees to pay the
former owners of XYZ Corp. additional consideration of $20 million after the acquisition
date if a specific revenue target of XYZ is achieved for the second-year period ending
December 31, 20X8. The revenue target is $100 million.
As part of evaluating the probability of achievement of the revenue target at the end of
20X8, ABC estimated the different outcomes, which reflect market participant
expectations, using an expected cash flow technique, as follows4:
Low case
Base case
Stretch case
Revenue
90,000
110,000
130,000
Probability
25.0%
50.0%
25.0%
100.0%
Weighted
Revenue
22,500
55,000
32,500
110,000
ABC has calculated the expected revenue for the second-year ending on December 31,
20X8 as $110,000. ABC determined that the appropriate continuous and annualized risk-
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adjusted discount rate for revenue is 15%, the revenue annual volatility is 35%, and the
continuous and annualized risk-free rate is 1.5%. The counterparty credit risk spread is
2%. Consistent with the midperiod convention, ABC assumes that the period to second-
year expected revenue realization is 1.5 years and that the $20 million payment will be
made on December 31, 20X8 (i.e., at 2.0 years).
ABC first calculates the expected present value of revenue as of January 1, 20X7 using
the mid-period convention:
$87,837 = $110,000 × exp(-15% × 1.5)
ABC applies the Black-Scholes-Merton model to determine the fair value of the
additional consideration as of January 1, 20X7 as follows:
Fair Value = Payment × exp(- Counterparty credit risk rate × Payment period)) × N(d2)
where counterparty credit risk rate is the sum of the risk-free rate and the counterparty
credit risk spread and N() is the standard normal distribution function with
d2 = [ ln($87,837/$100,000) + (1.5% - 0.5×35%^2) × 1.5 ] / [35% × 1.5^0.5] = -0.46
The fair value is calculated as:
Fair Value = $20 million × exp(- 3.5% × 2.0) × 32.12% = $6.0 million
The acquisition-date fair value of the contingent consideration is approximately $6.0
million, and is included in the consideration transferred. The contingency is liability-
classified and, as such, is remeasured to fair value each reporting period until the
contingency is settled. ABC recognizes adjustments resulting from remeasurement in
current earnings.
Example 18.3: Determining the Fair Value of Liability-Classified Contingent
Consideration--Scenario 3
As part of a business combination on January 1, 20X9, ABC Corp. agrees to pay the
former owners of XYZ Corp. additional consideration of $5 million if revenue of XYZ
for the year ending December 31, 20X9 is greater than $50 million. If this $50 million
revenue threshold is not achieved, then no additional consideration is payable.
ABC estimates the expected revenue of XYZ for the year ending December 31, 20X9 to
be $150 million, which is significantly above the $50 million revenue threshold. The
main purpose for structuring the contingent consideration was to defer $5 million of
consideration for one year, which is why the revenue threshold was set at such a low
level.
In determining the fair value of the contingent consideration, ABC considers that the
underlying metric (being future revenue) is systematic and, because of the $50 million
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threshold, the structure of the payoff is non-linear. For contingent consideration with a
non-linear structure based on a systematic underlying metric, the Option Pricing Method
would typically be most appropriate. However, given that the non-linear feature (i.e., the
threshold) is not operative (i.e., the threshold is so low that the payoff is approximately
linear) at the measurement date, ABC applies a Scenario Based Method.
Specifically, ABC first calculates the expected future payment to be $5 million (i.e.,
approximately 100% probability of achieving the threshold multiplied by the resulting
payment of $5 million). ABC then discounts the expected payment at a credit-adjusted
discount rate equal to the risk-free rate plus credit risk for one year. Since the likelihood
of achieving the $5 million payment is assumed to be 100%, the contingent consideration
mimics a vanilla debt instrument issued by ABC. ABC determines that the appropriate
continuous annualized risk-free rate is 1.5% and the counterparty credit risk spread of
ABC is 2%, considering the one-year term and subordinate nature of the obligation.
The fair value is calculated as:
Fair Value = 100% × $5 million × exp(- 3.5% × 1.0) = $4.8 million
The acquisition-date fair value of the contingent consideration is approximately $4.8
million, and is included in the consideration transferred. The contingency is liability-
classified and, as such, is remeasured to fair value each reporting period until the
contingency is settled.
ABC will continue to monitor the probability of achieving the threshold and, to the extent
this deviates from 100% probability, will reassess whether a Scenario Based Method is
still reasonable given the facts and circumstances at each future measurement date. If the
probability of achieving the threshold falls below 100% (i.e., it is no longer reasonable to
assume that the threshold will be achieved with certainty), then ABC will need to
consider the risk of the underlying revenue and the impact of the non-linear structure on
the value of the contingency, typically using an Option Pricing Method.
1 Risks that cannot be fully removed through diversification (such as risks that are correlated with the
market). Contingencies based on future revenue (or other financial metrics) are typically considered
systematic.
2 Risks that can be diversified away. For example, an event whose outcome is not influenced by movements
in the markets is a diversifiable risk; such risks are often illustrated by comparison to a coin flip.
Contingencies based on regulatory or technical approvals are often considered unsystematic.
3For non-linear payoff structures involving a metric with systematic (non-diversifiable) risk, the OPM uses
a risk-neutral framework to incorporate the impact of the non-linear structure on the risk of the contingent
cash flows. In this case using an SBM, the discount rate would have to be adjusted to account for the
impact of the non-linear payoff structure. However, the magnitude of the discount rate adjustment cannot
be easily estimated. It is for this reason that OPM is recommended over SBM in this situation.
4 For illustrative purposes, this example assumes three scenarios were considered by management. This is
not meant to suggest that three is always the correct number of scenarios to consider.
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Section 19 - Determining the Fair Value of
a Noncontrolling Interest in a Business
Combination
Detailed Contents
Fair Value of the Noncontrolling Interest In a Partial Acquisition
Overview
Control Premium
Valuation Analysis
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FAIR VALUE OF THE NONCONTROLLING INTEREST IN A
PARTIAL ACQUISITION
OVERVIEW
19.000 As discussed in Section 7, Recognizing and Measuring the Identifiable Assets
Acquired, the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree, in a
partial acquisition, the acquirer measures the noncontrolling interest in the acquiree at its
fair value at the date of acquisition.
19.001 Quoted market prices, if available, generally provide the best evidence of fair
value of the noncontrolling interest. For example, in a partial acquisition of a public
entity, an acquirer should measure the acquisition-date fair value of the noncontrolling
interest on the basis of the quoted market price for the equity shares not held by the
acquirer that continue to trade in an active market. However, in the absence of quoted
market prices (e.g., a privately held entity), it may be necessary to use a valuation
approach to determine the fair value of the noncontrolling interest.
19.002 As part of evaluating the best information available, the acquisition-date fair value
of the consideration transferred by an acquirer is generally not indicative of the fair value
of the noncontrolling interest. For example, the fair value of the acquirer’s controlling
interest in the acquiree and the noncontrolling interest on a per-share basis often differ.
That is, a control premium is often part of the per-share fair value of the acquirer’s
controlling interest in the acquiree, which would not be reflected in the per share amount
of any noncontrolling interest. ASC paragraph 805-20-30-8
CONTROL PREMIUM
19.003 A control premium1 represents the fact that an acquirer is willing to pay more for
equity securities that give it a controlling interest to take advantage of synergies and other
benefits that flow from control over another entity. For example, the controlling interest
may realize additional benefits from (i) improvements in cash flow, (ii) lower cost of
capital for the combined entity or (iii) additional features of the controlling interest that
are different from features of the noncontrolling interest. Alternatively, another investor
may be unwilling to pay as much for a number of equity securities representing less than
a controlling interest.
19.003a A control premium on the controlling interest therefore does not apply to the fair
value of a noncontrolling interest, except in the rare circumstance it is demonstrated that
the noncontrolling interests also will benefit from the market participant synergies and
other benefits of the combined entity after the business combination on a pro rata basis.
For example, synergies arising from a business combination might be in the form of
increased sales or cost efficiencies at the acquired entity. In that scenario, while the
acquirer might have paid an acquisition premium, all shareholders - both controlling and
noncontrolling - would participate in the value of these synergies on a pro rata basis, thus
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19. Determining the Fair Value of a Noncontrolling Interest
in a Business Combination
there would not be a difference in the per share value between the majority or controlling
interest and the noncontrolling interest. Conversely, if the synergies are realized only at
the acquirer or another subsidiary of the acquirer, the noncontrolling shareholders of the
acquired entity would not participate in the economic benefits realized from the
synergies. In this scenario there would be a control premium applicable to the controlling
interest and the noncontrolling interest would be valued at a discount from the controlling
interest.
VALUATION ANALYSIS
19.004 In the absence of quoted market prices for determining the fair value of the
noncontrolling interest, an acquirer uses other approaches to determine the fair value of
the noncontrolling interest. However, when using appropriate valuation technique(s), it
might be necessary to determine the acquisition-date fair value of the acquiree as a
whole, and then identify the portion that relates to the noncontrolling interest. We
generally would not expect an acquirer to determine the fair value of the noncontrolling
interest by grossing up the value of the controlling interest (e.g., simply concluding the
fair value of a 10% noncontrolling interest is $10 when the fair value of the controlling
interest is $90), unless there is evidence that the noncontrolling interest participates in all
benefits associated with control on a pro rata basis.
19.005 An AICPA Task Force developed a Practice Aid, Valuation of Privately-Held-
Company Equity Securities Issued as Compensation, on valuing private entities. See
Section 18, Determining the Fair Value of the Consideration Transferred in a Business
Combination, for additional discussion about the Practice Aid.
19.006 If the acquisition-date fair value of the acquiree as a whole is determined using
one or a combination of the valuation approaches described, it may be reasonable to
determine the fair value of the noncontrolling interest as the difference between the fair
value of the acquiree less the fair value of the consideration transferred by the acquirer.
Alternatively, an acquirer can use both market and income valuation approaches to
directly measure the fair value of the noncontrolling interest.
1 Control premium may also be referred to as a Market Participant Acquisition Premium (MPAP). The
MPAP is expressed through either enhanced cash flows or lower required rates of return.
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Section 20 - Determining the Fair Value of
a Previously Held Equity Interest in a
Business Combination
Detailed Contents
Fair Value of a Previously Held Equity Interest in an Acquiree in a Business
Combination Achieved in Stages (Step Acquisitions)
Overview
Valuation Analysis
Control Premium
Example 20.1: Previously Held Equity Interest Valued on a Pro Rata Basis
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20. Determining the Fair Value of a Previously Held
Equity Interest in a Business Combination
FAIR VALUE OF A PREVIOUSLY HELD EQUITY INTEREST IN AN
ACQUIREE IN A BUSINESS COMBINATION ACHIEVED IN
STAGES (STEP ACQUISITIONS)
OVERVIEW
20.000 As discussed in Section 9, Additional Guidance for Applying the Acquisition
Method to Particular Types of Business Combinations, in a business combination
achieved in stages, the acquirer measures its previously held interest in the acquiree at its
acquisition-date fair value and recognizes the resulting gain or loss, if any, in earnings at
the acquisition date. The amount recognized in earnings includes changes in value
previously recognized in other comprehensive income (e.g., when the previously held
interest was classified as an available-for-sale security).
20.001 Quoted market prices, if available, provide the best evidence of fair value of a
previously held interest in the acquiree. However, in the absence of quoted market prices
(e.g., a privately held entity), the fair value may need to be determined using valuation
approaches.
VALUATION ANALYSIS
20.002 Typically, techniques under the market approach or income approach provide the
best evidence of fair value in the absence of quoted market prices. Section 19,
Determining the Fair Value of the Noncontrolling Interest in a Business Combination,
provides additional guidance in determining the fair value of equity securities in the
absence of quoted market prices.
CONTROL PREMIUM
20.003 In September 2008, the FASB Valuation Resource Group (VRG) discussed
whether the fair value measurement of a previously held interest should include a control
premium. Although the VRG did not reach a conclusion at that meeting, an observer to
the joint FASB/IASB business combination project team believes that the intent of the
FASB was to exclude any control premium to determine the gain or loss on a previously
held equity interest because that interest did not represent a controlling interest before the
business combination. The measurement of the previously held equity interest in a
business combination achieved in stages should not reflect a control premium, and the
entire control premium should be attributed to the additional interest that was newly
acquired to obtain control (i.e., any control premium in a step acquisition would be
subsumed into goodwill). However, in limited circumstances it may be appropriate to
incorporate a control premium when an entity can demonstrate that the previously held
equity interest would benefit from the control transaction’s proceeds on a pro rata basis.
This might be the case when the previously held interest is subject to tag-along rights or
drag-along rights, or other minority shareholders (other than the acquirer) would receive
a pro rata share under the transaction structure. This is consistent with the FASB’s
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20. Determining the Fair Value of a Previously Held
Equity Interest in a Business Combination
conclusion in paragraph B382 of FASB Statement No. 141(R), Business Combinations,
in which an acquirer overpays for its interest in an acquiree, and that overpayment is
subsumed in goodwill, but does not result in a loss in earnings at the acquisition date.
Example 20.1: Previously Held Equity Interest Valued on a Pro Rata Basis
ABC Corp. is a minority investor in Target with 5 percent ownership of the common
shares. Aside from ABC, Target has three shareholders that each hold a 5 percent
interest with a fifth shareholder owning the remaining 80 percent.
ABC enters into an agreement with the other shareholders to buy the other
shareholders' shares (totaling 95%) for $95. The agreement stipulates that each investor
receives their proportionate share of the $95. This means the other three minority
investors receive $5 each and the majority investor receives $80.
ABC values its previously held interest at $5 because those shares have the same value
as the other shareholders.
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Section 21 - Not used
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Section 22 - Goodwill and Other
Intangible Assets*
Detailed Contents
Goodwill and Other Intangible Assets
Scope of ASC Topics 805 and 350 Related to the Accounting for Goodwill and Other
Intangible Assets
ASC Topic 805
ASC Topic 350
Accounting Guidance under Other Literature
Initial Recognition of Intangible Assets
Internally Developed Goodwill and Other Intangible Assets
Variable Interest Entities
Excess Reorganization Value in Bankruptcy
Intangible Assets Acquired in a Business Combination (Including Goodwill)
Acquisition of Intangible Assets in Transactions That Do Not Constitute the Acquisition
of a Business
Subsequent Accounting for Goodwill and Other Intangible Assets
Finite versus Indefinite Life
Determining and Evaluating the Useful Life of an Intangible Asset
Buyer-Specific Intent
Renewals or Extensions
Example 22.2: An Acquired Technology License That Renews Annually
Example 22.3: An Acquired Customer Relationship
Reacquired Rights
Other Examples of Determining the Useful Life of an Intangible Asset
Example 22.4: Intangible Assets--Amortizable and Nonamortizable
Example 22.5: Potential Indefinite-Lived Intangible Assets
Amortizable Intangible Assets
Amortization Period and Method
Amortization Period
Amortization Method
Example 22.6: Amortization Methods
Residual Value
Reevaluation of Useful Life
Impairment of Amortizable Intangible Assets
Nonamortizable Intangible Assets Other Than Goodwill
Indefinite-Lived Intangible Assets Are Not Amortized
Intangible Assets Acquired in a Business Combination That Are Used in
Research and Development Activities
Impairment of Identifiable Indefinite-Lived Intangible Assets
Goodwill
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22. Goodwill and Other Intangible Assets
* This section discusses the accounting for goodwill by public business entities and
other entities that do not elect the Private Company Council (PCC) alternatives. The
requirements under the PCC alternatives are discussed in Section 26, Private Company
and Not-for-Profit Accounting Alternatives.
GOODWILL AND OTHER INTANGIBLE ASSETS
22.000 Goodwill is defined as follows:
ASC Master Glossary: Goodwill
An asset representing the future economic benefits arising from other assets
acquired in a business combination or an acquisition by a not-for-profit entity that
are not individually identified and separately recognized. …
22.001 Intangible assets are defined as:
ASC Master Glossary: Intangible Assets
Assets (not including financial assets) that lack physical substance. (The term
intangible assets is used to refer to intangible assets other than goodwill).
22.002 While goodwill is, by definition, an intangible asset, the term intangible assets, as
used in both ASC Topic 805, Business Combinations and ASC Topic 350, Intangibles--
Goodwill and Other, generally excludes goodwill, which is discussed in those Topics
separately from other intangible assets. These definitions also reflect the fact that
intangible assets, as the term is used in ASC Topics 805 and 350, are individually
recognized and measured, while goodwill is measured as the residual amount in the
acquisition accounting (see Section 8, Recognizing and Measuring Goodwill or a Gain
from a Bargain Purchase).
SCOPE OF ASC TOPICS 805 AND 350 RELATED TO THE
ACCOUNTING FOR GOODWILL AND OTHER INTANGIBLE
ASSETS
22.003 The guidance in ASC Topics 805 and 350 for the initial recognition and
measurement of, and subsequent accounting for, goodwill and other intangible assets is
summarized below:
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Internally Developed Intangible
Assets
Other Intangible Assets
22. Goodwill and Other Intangible Assets
Initial Recognition and
Measurement
Subsequent
Accounting
ASC Topic 350 and other
applicable GAAP (e.g.,
ASC Subtopic985-20)
ASC Topic 350
and ASC Section
360-10-35 and
other applicable
GAAP
Goodwill and Other Intangible
Assets Acquired in a Business
Combination
Goodwill
Other Intangible Assets
ASC Topic 805
ASC Topic 805
Other Intangible Assets Acquired in
an Acquisition of Assets Not
Constituting a Business
Other than IPR&D
ASC Topic 350
IPR&D
ASC Topics 730 and 350
ASC Topic 350
ASC Topic 350
and ASC Section
360-10-35 and
other applicable
GAAP
ASC Topic 350
and ASC Section
360-10-35 and
other applicable
GAAP
ASC Subtopic
730-10
ASC TOPIC 805
22.004 ASC Topic 805 addresses the initial recognition and measurement of goodwill
and other intangible assets acquired in a business combination. See discussion in Sections
7, Recognizing and Measuring the Identifiable Assets Acquired, the Liabilities Assumed,
and Any Noncontrolling Interest in the Acquiree, 8, and 26, Private Company and Not-
for-Profit Accounting Alternatives.
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22. Goodwill and Other Intangible Assets
ASC TOPIC 350
22.005 ASC Topic 350 addresses the initial recognition and measurement of other
intangible assets developed internally or acquired in an asset acquisition, and the
subsequent accounting for goodwill and other intangible assets, regardless of how they
were acquired.
ASC Paragraph 350-10-05-1
The Intangibles--Goodwill and Other Topic provides guidance on financial
accounting and reporting related to goodwill and other intangible assets, including
the subsequent measurement of goodwill and intangible assets. It does not include
guidance on the accounting at acquisition for goodwill and other intangibles
acquired in a business combination or an acquisition by a not-for-profit entity.
ASC Paragraph 350-20-05-1
[ASC] Subtopic [350-20] addresses financial accounting and reporting for
goodwill subsequent to its acquisition and for the cost of internally developing
goodwill.
ASC Paragraph 350-20-05-2
[ASC] Subtopic 805-30 provides guidance on recognition and initial measurement
of goodwill in a business combination. [ASC] Subtopic 958-805 provides
guidance on recognition and initial measurement of goodwill acquired in an
acquisition by a not-for-profit entity.
ASC Paragraph 350-20-15-2
The guidance in [ASC] Subtopic [350-20] applies to the following transactions
and activities:
a. Goodwill that an entity recognizes in accordance with [ASC] Subtopic
805-30 or [ASC] Subtopic 958-805 after it has been initially recognized and
measured
b. The costs of internally developing goodwill and other unidentifiable
intangible assets with indeterminate lives
c. Subparagraph Not Used
d. Amounts recognized as goodwill in applying the equity method of
accounting and to the excess reorganization value recognized by entities that
adopt fresh-start reporting in accordance with [ASC] Topic 852.
e. Subparagraph Not Used
ASC Paragraph 350-30-05-1
[ASC] Subtopic [350-30] addresses financial accounting and reporting for
intangible assets (other than goodwill) acquired individually or with a group of
other assets and for the cost of developing, maintaining, or restoring internally
generated intangible assets. However, it does not discuss the recognition and
initial measurement of intangible assets acquired in a business combination or in
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22. Goodwill and Other Intangible Assets
an acquisition by a not-for-profit entity. [ASC] Subtopic [350-30] also addresses
financial accounting and reporting for intangible assets after their acquisition,
including intangible assets acquired in a business combination or an acquisition
by a not-for-profit entity.
Accounting Guidance under Other Literature
22.006 ASC Topic 350 does not change the accounting for intangible assets prescribed in
other accounting pronouncements identified in ASC paragraph 350-10-15-4. Thus, the
accounting for intangible assets in the following pronouncements remains applicable:
(a) ASC Subtopic 730-10, Research and Development - Overall.
(b) ASC Topic 932, Extractive Activities--Oil and Gas.
(c) ASC Topic 928, Entertainment--Music.
(d) ASC Topic 950, Financial Services--Title Plant.
(e) ASC Topic 920, Entertainment--Broadcasters.
(f) ASC paragraphs 980-350-35-1 through 35-2 for rate-regulated activities.
(g) ASC Topic 985, Software.
(h) ASC Topic 740, Income Taxes.
(i) ASC Topic 860, Transfers and Servicing.
22.007 While not specifically cited in ASC Topic 350, it does not change the accounting
for specific intangible assets provided by other authoritative GAAP such as ASC Topic
908, Airlines; ASC Subtopic 720-35, Other Expenses - Advertising Costs; ASC Subtopic
350-40, Intangibles--Goodwill and Other - Internal-Use Software; ASC Subtopic 720-15,
Other Expenses - Start-Up Costs; and ASC Topic 926, Entertainment--Films.
INITIAL RECOGNITION OF INTANGIBLE ASSETS
Internally Developed Goodwill and Other Intangible Assets
ASC Paragraph 350-20-25-3
Costs of internally developing, maintaining, or restoring intangible assets
(including goodwill) that are not specifically identifiable, that have indeterminate
lives, or that are inherent in a continuing business and related to an entity as a
whole, shall be recognized as an expense when incurred.
22.008 ASC Topic 350 requires that the costs of internally developing, maintaining, or
restoring intangible assets meeting the criterion in ASC paragraph 350-30-25-3 be
recognized as expense as incurred.
22.009 ASC paragraph 350-30-15-3, however, specifies that ASC Topic 350 also applies
to costs of internally developing identifiable assets that an entity recognizes as assets.
Accounting guidance for internally developed identifiable intangible assets that are
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22. Goodwill and Other Intangible Assets
recognized as assets by reporting entities generally is included in the pronouncements
addressed in the above discussion, Accounting Guidance under Other Literature.
However, if ASC Topic 350 includes additional requirements that go beyond, but are not
inconsistent with the other pronouncements applied, such as additional disclosure
requirements, the additional requirements of ASC Topic 350 are applicable to that
intangible asset.
VARIABLE INTEREST ENTITIES
22.010 ASC Subtopic 810-10, Consolidation - Overall, requires an entity that becomes
the primary beneficiary of a variable interest entity that does not constitute a business
initially measures and recognizes the assets, except goodwill, and liabilities of the
variable interest entity in accordance with the recognition and measurement principles of
ASC Sections 805-20-25 and 805-20-30. However, the primary beneficiary should
recognize a gain or loss for the difference between: (1) the fair value of any consideration
transferred, the fair value of any noncontrolling interests, and the reported amount of any
previously held interests; and (2) the net amount of the variable interest entity’s
identifiable assets and liabilities recognized and measured in accordance with ASC
Sections 805-20-25 and 805-20-30. Consistent with ASC Topic 350, no goodwill should
be recognized if the variable interest entity is not a business.
22.011 See Section 4, Variable Interest Entities, for additional discussion on accounting
for variable interest entities.
EXCESS REORGANIZATION VALUE IN BANKRUPTCY
22.012 ASC Subtopic 852-10, Reorganizations - Overall, indicates that when applying
fresh-start accounting upon emergence from bankruptcy, the reorganization value should
be assigned to the entity’s assets, liabilities and equity in conformity with the procedures
specified by ASC Topic 805, including its provisions for initial recognition and
measurement of intangible assets apart from goodwill. The excess reorganization value
recognized by emerging entities that adopt fresh-start reporting under ASC Subtopic 852-
10 is reported and accounted for in the same manner as goodwill arising in a business
combination. See KPMG Handbook, Accounting for bankruptcies, for an in-depth
discussion of the accounting for bankruptcies. Statement 142, par. B18
INTANGIBLE ASSETS ACQUIRED IN A BUSINESS
COMBINATION (INCLUDING GOODWILL)
22.013 The initial recognition and measurement of goodwill and other intangible assets
acquired in a business combination is discussed in the following Sections:
• The initial recognition and measurement of goodwill arising from a business
combination is discussed in Section 8, Recognizing and Measuring Goodwill
or a Gain from a Bargain Purchase.
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22. Goodwill and Other Intangible Assets
• The initial recognition and measurement of other intangible assets acquired in
a business combination is discussed in Section 7, Recognizing and Measuring
the Identifiable Assets Acquired, the Liabilities Assumed, and Any
Noncontrolling Interest in the Acquiree.
ACQUISITION OF INTANGIBLE ASSETS IN TRANSACTIONS
THAT DO NOT CONSTITUTE THE ACQUISITION OF A BUSINESS
22.014 For guidance on accounting for intangible assets in an asset acquisition, see
section 4.2 in KPMG Handbook, Asset acquisitions.
22.015 – 22.019 Paragraphs not used.
Example 22.1 Not used.
SUBSEQUENT ACCOUNTING FOR GOODWILL AND OTHER
INTANGIBLE ASSETS
22.020 The accounting for other intangible assets subsequent to their acquisition is the
same, regardless of whether they are acquired in a business combination or in an
acquisition of assets, with the exception of reacquired rights acquired in a business
combination (see discussion under Reacquired Rights below).
FINITE VERSUS INDEFINITE LIFE
22.021 The subsequent accounting for an intangible asset depends on whether its useful
life is finite or indefinite. An intangible asset with a finite useful life is amortized, while
an intangible asset with an indefinite useful life is not. An intangible asset has an
indefinite life if there are no legal, regulatory, contractual, competitive, economic, or
other factors limiting its life. Useful life is defined as the period over which an asset is
expected to contribute directly or indirectly to future cash flows. An indefinite useful life
is defined as extending beyond the foreseeable horizon, i.e., there is no foreseeable limit
on the period of time over which the asset is expected to contribute to the cash flows of
the reporting entity. ASC paragraph 350-30-35-4
22.022 Unless an intangible asset’s life extends beyond the foreseeable horizon, an entity
is required to assign it a useful life – even if a precise useful life for the asset cannot be
determined. In such cases, the entity uses its best estimate of the intangible asset’s useful
life. For example, the useful life of a patent can typically be determined with precision
because a patent has a clear expiration date under U.S. federal law and cannot be
renewed. In contrast, the useful life of magazine subscriber relationships typically cannot
be easily determined because an unknown number of subscribers will renew their current
subscriptions. In the case of subscribers, the entity needs to estimate the period over
which the underlying relationships will continue. This can be difficult and requires
judgment based on the individual facts and circumstances; however, the SEC staff has
stated that it would be extremely rare for any type of customer relationship intangible to
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22. Goodwill and Other Intangible Assets
have an indefinite life. As another example, airport slotting rights are also renewable
when their contractual period expires. In contrast to the magazine subscriber
relationships, an airline is likely to find it easier to determine that renewals will occur
indefinitely – i.e., beyond the foreseeable horizon. This is because of longstanding
industry practice of airlines being offered renewals to slotting rights given the critical
nature of those rights to the airlines’ operations. In that case, the slotting rights may be
indefinite-lived intangible assets.
22.023 Some mature products and brand names might be considered to have indefinite
lives. In contrast, a young brand or product typically has a finite useful life initially, but
the passage of time and more evidence might lead to a conclusion that the life has
changed to indefinite. For example, an acquired brand name that has been in the market
for only a few years would likely not be considered to have an indefinite life, but after a
longer history of stable cash flows, that conclusion might change. However, in our
experience, it is uncommon for finite-lived intangible assets to become indefinite-lived
intangible assets. Conversely, an indefinite-lived intangible asset may subsequently be
determined to have a finite useful life. In this case, the intangible asset’s carrying amount
is first tested for impairment under ASC Subtopic 350-30 – i.e., a quantitative test is
required unless the entity chooses to carry out (and passes) a qualitative assessment. Then
the entity amortizes the remaining carrying amount over the new estimated useful life.
Subsequently, the asset is tested for impairment under ASC Topic 360 at each reporting
date if a triggering event has occurred. An entity reassesses the classification each
reporting period, which is discussed further starting in Paragraph 22.036.
DETERMINING AND EVALUATING THE USEFUL LIFE OF AN INTANGIBLE ASSET
ASC Paragraph 350-30-35-1
The accounting for a recognized intangible asset is based on its useful life to the
reporting entity. An intangible asset with a finite useful life shall be amortized; an
intangible asset with an indefinite useful life shall not be amortized.
ASC Paragraph 350-30-35-2
The useful life of an intangible asset to an entity is the period over which the asset
is expected to contribute directly or indirectly to the future cash flows of that
entity. The useful life is not the period of time that it would take that entity to
internally develop an intangible asset that would provide similar benefits.
However, a reacquired right recognized as an intangible asset is amortized over
the remaining contractual period of the contract in which the right was granted. If
an entity subsequently reissues (sells) a reacquired right to a third party, the entity
includes the related unamortized asset, if any, in determining the gain or loss on
the reissuance.
ASC Paragraph 350-30-35-3
The estimate of the useful life of an intangible asset to an entity shall be based on
an analysis of all pertinent factors, in particular, the following factors with no one
factor being more presumptive than the other:
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22. Goodwill and Other Intangible Assets
a. The expected use of the asset by the entity.
b. The expected useful life of another asset or a group of assets to which the
useful life of the intangible asset may relate.
c. Any legal, regulatory, or contractual provisions that may limit the useful
life. The cash flows and useful lives of intangible assets that are based on
legal rights are constrained by the duration of those legal rights. Thus, the
useful lives of such intangible assets cannot extend beyond the length of their
legal rights and may be shorter.
d. The entity’s own historical experience in renewing or extending similar
arrangements, consistent with the intended use of the asset by the entity,
regardless of whether those arrangements have explicit renewal or extension
provisions. In the absence of that experience, the entity shall consider the
assumptions that market participants would use about renewal or extension
consistent with the highest and best use of the asset by market participants,
adjusted for entity-specific factors in this paragraph.
e. The effects of obsolescence, demand, competition, and other economic
factors (such as the stability of the industry, known technological advances,
legislative action that results in an uncertain or changing regulatory
environment, and expected changes in distribution channels).
f. The level of maintenance expenditures required to obtain the expected
future cash flows from the asset (for example, a material level of required
maintenance in relation to the carrying amount of the asset may suggest a very
limited useful life). As in determining the useful life of depreciable tangible
assets, regular maintenance may be assumed but enhancements may not.
Further, if an income approach is used to measure the fair value of an intangible
asset, in determining the useful life of the intangible asset for amortization
purposes, an entity shall consider the period of expected cash flows used to
measure the fair value of the intangible asset adjusted as appropriate for the
entity-specific factors in this paragraph.
ASC Paragraph 350-30-35-4
If no legal, regulatory, contractual, competitive, economic, or other factors limit
the useful life of an intangible asset to the reporting entity, the useful life of the
asset shall be considered to be indefinite. The term indefinite does not mean the
same as infinite or indeterminate. The useful life of an intangible asset is
indefinite if that life extends beyond the foreseeable horizon - that is, there is no
foreseeable limit on the period of time over which it is expected to contribute to
the cash flows of the reporting entity. Such intangible assets might be airport
route authorities, certain trademarks, and taxicab medallions.
ASC Paragraph 350-30-35-5
Examples 1 through 9B (see [ASC] paragraphs 350-30-55-2 through 55-28F)
illustrate different intangible assets and how they should be accounted for in
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22. Goodwill and Other Intangible Assets
accordance with this Subtopic, including determining whether the useful life of an
intangible asset is indefinite.
Buyer-Specific Intent
22.024 In determining the useful life of an intangible asset (or whether an intangible asset
is indefinite lived), an entity should consider its intended use for the intangible asset
(ASC paragraph 350-30-35-2). There can be a difference between the useful life of the
asset and the period of cash flows used to measure the fair value of the asset based on
assumptions market participants would use to price the asset.
22.025 Other factors that should be considered in determining the useful life of an
intangible asset include:
• Relative stability of the cash flow forecast for the intangible asset;
• Relative stability of the cash flow history for the intangible asset;
• Period of time a product or concept has been in the market;
• Whether revenues are dependent on retaining key employees;
• Churn rate for customers;
• Mobility of customer and employee bases;
• Assumptions used to assess the asset for impairment; and
• Assumptions used to determine the fair value of the asset.
Renewals or Extensions
22.026 ASC paragraph 350-30-35-3(d) is intended to provide for greater consistency
between the useful life of a recognized intangible asset and the period of expected cash
flows used to measure the fair value of the asset. To achieve this, ASC paragraph 350-30-
35-3(d) specifies that in developing assumptions about renewals or extensions used in
determining the useful life of a recognized intangible asset, an entity should consider its
own historical experience in renewing or extending similar arrangements (consistent with
the entity’s intended use of the asset), regardless of whether those arrangements have
explicit renewal or extension provisions. In the absence of such experience, an entity
considers the assumptions that market participants would use about renewal or extension
(consistent with the highest and best use of the asset by market participants), adjusted for
the entity-specific factors in ASC paragraphs 350-30-35-1 through 5.
22.027 The following examples illustrate the application of ASC Subtopic 350-30.
Example 22.2: An Acquired Technology License That Renews Annually
An exclusive, annually renewable technology license with a third party is acquired by an
entity that has made significant progress in developing next-generation technology for
digital video products. The acquiring entity believes that in two years, after it has
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22. Goodwill and Other Intangible Assets
completed developing its next-generation products, the acquired technology license will
be obsolete because customers will convert to the acquiring entity’s products. Market
participants, however, are not as advanced in their development efforts and are not aware
of the acquiring entity’s proprietary development efforts. Thus, those market participants
would expect the technology license to be obsolete in three years. The acquiring entity
determines that the fair value of the technology license utilizing 3 years of cash flows is
$10 million, consistent with the highest and best use of the asset by market participants.
In applying ASC paragraph 350-30-35-3(d), the acquiring entity considers its own
historical experience in renewing or extending similar arrangements. In this case, the
acquiring entity lacks historical experience in renewing or extending similar
arrangements. Therefore, it considers the assumptions that a market participant would use
consistent with the highest and best use of the technology license. However, because the
acquiring entity expects to use the technology license until it becomes obsolete in two
years, it adjusts the market participants’ assumptions for the entity-specific factors in
ASC paragraph 350-30-35-3(a), which requires consideration of the entity’s expected use
of the asset. As a result, the technology license will be amortized over a two-year period.
The technology license will be reviewed for impairment under ASC Section 360-10-35.
Example 22.3: An Acquired Customer Relationship
An insurance company acquires 50 customer relationships operating under contracts that
are renewable annually. The acquiring entity determines that the fair value of the
customer relationship asset is $10 million, considering assumptions (including turnover
rate) that a market participant would make consistent with the highest and best use of the
asset by market participants. An income approach was used to determine the fair value of
the acquired customer relationship asset.
In applying ASC paragraph 350-30-35-3(d), the acquiring entity considers its own
historical experience in renewing or extending similar customer relationships. In this
case, the acquiring entity concludes that its customer relationships are dissimilar to the
acquired customer relationships and, therefore, the acquiring entity lacks historical
experience in renewing or extending similar arrangements. Accordingly, the acquiring
entity considers turnover assumptions that market participants would make about the
renewal or extension of the acquired customer relationships or similar arrangements.
Without evidence to the contrary, the acquiring entity expects that the acquired customer
relationships will be renewed or extended at the same rate as a market participant would
expect, and no other factors indicate a different useful life is appropriate. Thus, absent
any other of the entity-specific factors in ASC paragraphs 350-30-35-1 through 35-5, in
determining the useful life for amortization purposes, the acquiring entity considers the
period of expected cash flows used to measure the fair value of the asset. The customer
relationships will be reviewed for impairment under ASC Section 360-10-35.
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22.028 In evaluating whether renewal or extension rights should be considered in
determining the estimated useful life of an intangible asset, the acquirer should have both
the intent and the ability to renew or extend the intangible asset. The acquirer’s past
practice of not renewing or extending comparable intangible assets may evidence a lack
of the requisite intent or ability to do so. When evaluating an ability to renew or extend
an intangible asset, a number of factors should be considered, including the acquiree’s
past practices, industry practices, the past practices of the party granting the intangible
asset, and the nature of the party granting the right (e.g., governmental entities may be
more likely to treat all parties equally which may limit the ability of the existing holder to
renew an intangible asset).
Reacquired Rights
22.029 In some business combinations, an acquirer reacquires a right that it previously
granted to the acquiree to use one or more of the acquirer’s recognized or unrecognized
assets. For example, the acquirer may have previously granted the acquiree a right to use
the acquirer’s trade name under a franchise agreement or a right to use the acquirer’s
technology under a technology licensing agreement. ASC Topic 805 requires that a right
reacquired in a business combination be measured on the basis of the remaining
contractual term of the related contract, without regard to whether market participants
would consider potential contractual renewals in determining its fair value. ASC Topic
805 also provides guidance on the subsequent accounting for a reacquired right,
consistent with its initial measurement, requiring that it be amortized over the remaining
contractual period of the contract in which the right was granted without regard to the
criteria in ASC paragraphs 350-30-35-1 through 35-5. Refer to additional discussion
about reacquired rights at Paragraph 11.015. ASC paragraphs 805-20-30-20 and 35-2
Other Examples of Determining the Useful Life of an Intangible Asset
22.030 The following examples illustrate the application of the criteria of ASC Section
350-30-35 in determining useful lives of intangible assets. Examples 1 through 9B are
taken from ASC paragraphs 350-30-55-2 through 55-28F.
Example 22.4: Intangible Assets--Amortizable and Nonamortizable
1. An acquired customer list. A direct-mail marketing company acquired a customer list
and expects that it will be able to derive benefit from the information on the acquired
customer list for at least one year but for no more than three years.
The customer list will be amortized over 18 months, management’s best estimate of its
useful life, following the pattern in which the expected benefits will be consumed or
otherwise used up. Although the acquiring company intends to add customer names and
other information to the list in the future, the expected benefits of the acquired customer
list relate only to the customers on that list at the date of acquisition (a closed-group
notion). The customer list will be reviewed for impairment under ASC Section 360-10-35.
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22. Goodwill and Other Intangible Assets
2. An acquired patent that expires in 15 years. The product protected by the patented
technology is expected to be a source of cash flows for at least 15 years. The reporting
entity has a commitment from a third party to purchase the patent in 5 years for 60% of
the fair value of the patent at the date it was acquired, and the entity intends to sell the
patent in 5 years.
The patent will be amortized over its 5-year useful life to the reporting entity, following
the pattern in which the expected benefits will be consumed or otherwise used up. The
amount to be amortized is 40% of the patent’s fair value at the acquisition date (residual
value is 60%). The patent will be reviewed for impairment under ASC Section 360-10-35.
3. An acquired copyright that has a remaining legal life of 50 years. An analysis of
consumer habits and market trends provides evidence that the copyrighted material will
generate cash flows for approximately 30 more years.
The copyright will be amortized over its 30-year estimated useful life, following the
pattern in which the expected benefits will be consumed or otherwise used up and
reviewed for impairment under ASC Section 360-10-35.
4. An acquired broadcast license that expires in five years. The broadcast license is
renewable every 10 years if the company provides at least an average level of service to
its customers and complies with the applicable Federal Communications Commission
(FCC) rules and policies and the FCC Communications Act of 1934. The license may be
renewed indefinitely at little cost and was renewed twice prior to its recent acquisition.
The acquiring entity intends to renew the license indefinitely, and evidence supports its
ability to do so. Historically, there has been no compelling challenge to the license
renewal. The technology used in broadcasting is not expected to be replaced by another
technology any time in the foreseeable future. Therefore, the cash flows from the license
are expected to continue indefinitely.
The broadcast license is deemed to have an indefinite useful life because cash flows are
expected to continue indefinitely. Therefore, the license will not be amortized until its
useful life is deemed to be no longer indefinite. The license will be tested for impairment
in accordance with ASC paragraph 350-30-35-18 through 35-20.
5. For the broadcast license in Example 4. The FCC subsequently decides that it will
no longer renew broadcast licenses, but rather will auction those licenses. At the time the
FCC decision is made, the broadcast license has three years until it expires. The cash
flows from that license are expected to continue until the license expires.
Because the broadcast license can no longer be renewed, its useful life is no longer
indefinite. Thus, the acquired license is tested for impairment in accordance with ASC
paragraph 350-30-35-18 through 20. The license is then amortized over its remaining
three-year useful life following the pattern in which the expected benefits will be
consumed or otherwise used up. Because the license will be subject to amortization, in
the future it will be reviewed for impairment under ASC Section 360-10-35.
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22. Goodwill and Other Intangible Assets
6. An acquired airline route authority from the United States to the United
Kingdom that expires in three years. The route authority may be renewed every five
years, and the acquiring entity intends to comply with the applicable rules and regulations
surrounding renewal. Route authority renewals routinely are granted at a minimal cost
and have historically been renewed when the airline has complied with the applicable
rules and regulations. The acquiring entity expects to provide service to the United
Kingdom from its hub airports indefinitely and expects that the related supporting
infrastructure (airport gates, slots, and terminal facility leases) will remain in place at
those airports for as long as it has the route authority. An analysis of demand and cash
flows supports those assumptions.
Because the facts and circumstances support the acquiring entity’s ability to continue
providing air service to the United Kingdom from its U.S. hub airports indefinitely, the
intangible asset related to the route authority is considered to have an indefinite useful
life. Therefore, the route authority will not be amortized until its useful life is deemed to
be no longer indefinite and will be tested for impairment in accordance with ASC
paragraphs 350-30-35-18 through 35-20.
7. An acquired trademark that is used to identify and distinguish a leading
consumer product that has been a market-share leader for the past eight years. The
trademark has a remaining legal life of five years but is renewable every 10 years at little
cost. The acquiring entity intends to continuously renew the trademark, and evidence
supports its ability to do so. An analysis of product life cycle studies; market,
competitive, and environmental trends; and brand extension opportunities provide
evidence that the trademarked product will generate cash flows for the acquiring
company for an indefinite period of time.
The trademark is deemed to have an indefinite useful life because it is expected to
contribute to cash flows indefinitely. Therefore, the trademark will not be amortized until
its useful life is no longer indefinite. The trademark will be tested for impairment in
accordance with ASC paragraphs 350-30-35-18 through 35-20.
8. A trademark that distinguished a leading consumer product that was acquired 10
years ago. When it was acquired, the trademark was considered to have an indefinite
useful life because the product was expected to generate cash flows indefinitely. During
the annual impairment testing of the intangible asset, the entity determines that
unexpected competition has entered the market that will reduce future sales of the
consumer product. Management estimates that cash flows generated by the product will
be 20% less for the foreseeable future; however, management expects that the product
will continue to generate cash flows indefinitely at those reduced amounts.
As a result of the projected decrease in future cash flows, the entity determines that the
estimated fair value of the trademark is less than its carrying amount, and an impairment
loss is recognized. Because the trademark is still deemed to have an indefinite useful life,
it will continue to not be amortized and will instead be tested for impairment in
accordance with ASC paragraphs 350-30-35-18 through 35-20.
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22. Goodwill and Other Intangible Assets
9. A trademark for a line of automobiles that was acquired several years ago in an
acquisition of an automobile company. The line of automobiles had been produced by
the acquired entity for 35 years with numerous new models developed under the
trademark. At the acquisition date, the acquiring entity expected to continue to produce
that line of automobiles, and an analysis of various economic factors indicated there was
no limit to the period of time the trademark would contribute to cash flows. Because cash
flows were expected to continue indefinitely, the trademark was not amortized.
Management recently decided to phase out production of that automobile line over the
next four years.
Because the useful life of the acquired trademark is no longer deemed to be indefinite, the
trademark is tested for impairment in accordance with ASC paragraphs 350-30-35-18
through 35-20. The carrying amount of the trademark after adjustment, if any, will then
be amortized over its remaining four-year useful life following the pattern in which the
expected benefits will be consumed or otherwise used up. Because the trademark will
now be subject to amortization, in the future it will be reviewed for impairment under
ASC Section 360-10-35.
22.031 The franchise rights and investment management contract examples below
describe possible circumstances in which an intangible asset may have an indefinite
useful life. However, the analysis is highly dependent on the facts and circumstances, and
judgment will be required.
Example 22.5: Potential Indefinite-Lived Intangible Assets
Example 1. An acquired company has a portfolio of owned or franchised fast food chain
restaurants. The restaurants operate under a well-known brand name and the acquired
company has historically been profitable. The restaurant brand name is expected to
continue to generate positive cash flow for the acquirer beyond the foreseeable future.
The fast food chain restaurants are in a mature, steady-growth stage of their life cycle.
Therefore, the brand name may have an indefinite useful life. If so, the acquired brand
name would not be amortized until its useful life is no longer deemed to be indefinite and
would be tested for impairment on an annual basis in accordance with ASC Topic 350.
Example 2. An acquired investment advisory firm has an investment management
contract with a registered mutual fund. The contract can be renewed annually by mutual
agreement of both parties. The mutual fund and its advisor have had an ongoing
relationship for the last five years and the contract has been renewed each year. Although
the mutual fund can terminate the contract on short notice, the contract is not expected to
be terminated any time in the foreseeable future.
Because the specific facts and circumstances support the company’s ability to renew the
contract indefinitely, the intangible asset related to the contractual relationship may have
an indefinite useful life and if so would not be amortized but would be tested for
impairment on an annual basis in accordance with ASC Topic 350.
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AMORTIZABLE INTANGIBLE ASSETS
Amortization Period and Method
ASC Paragraph 350-30-35-6
A recognized intangible asset shall be amortized over its useful life to the
reporting entity unless that life is determined to be indefinite. If an intangible
asset has a finite useful life, but the precise length of that life is not known, that
intangible asset shall be amortized over the best estimate of its useful life. The
method of amortization shall reflect the pattern in which the economic benefits of
the intangible asset are consumed or otherwise used up. If that pattern cannot be
reliably determined, a straight-line amortization method shall be used.
ASC Paragraph 350-30-35-7 (in part)
An intangible asset shall not be written down or off in the period of acquisition
unless it becomes impaired during that period…
Amortization Period
22.032 An intangible asset is amortized over its useful life to the reporting entity, unless
its life is determined to be indefinite. An intangible asset is not written down or off in the
period of acquisition unless it becomes impaired during that period. IPR&D assets
acquired in a business combination are measured and recognized at fair value regardless
of their alternative future use rather than expensed at the acquisition date. ASC
paragraphs 350-30-35-6 through 35-7
22.033 A business combination may result in the acquisition of assets that an entity does
not intend to actively use but does intend to prevent others from using. Such assets are
commonly referred to as defensive intangible assets or locked-up assets. Under ASC
Topic 805, an acquirer recognizes and measures all intangible assets, including defensive
intangible assets, at fair value determined in accordance with ASC Topic 820. ASC
Subtopic 350-30 provides guidance as to how defensive intangible assets should be
accounted for subsequent to their acquisition. Refer to Section 12, Subsequent
Measurement and Accounting, for additional discussion of the accounting for defensive
intangible assets.
Amortization Method
22.034 An amortizable intangible asset is amortized over its estimated useful life to its
estimated residual value in accordance with the pattern of consumption of the economic
benefits inherent in the intangible asset. Because we believe that the focus should be on
using up the rights conveyed by the intangible asset, amortization in proportion to
estimated revenues (or similar measure) generally would not be appropriate when it
results in a back-ended amortization of the intangible asset. If a pattern of consumption
cannot be reliably determined, the straight-line method should be used. The pattern in
which economic benefits are consumed may be estimated using either a discounted or
undiscounted cash flow basis. The difference in amortization between the two methods is
illustrated below.
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22. Goodwill and Other Intangible Assets
Example 22.6: Amortization Methods
Assume that the intangible asset has estimated undiscounted cash flows of $100.
Assuming a 10% discount rate and a five-year life, the present value of the asset would
be $75.8. The following table illustrates the pattern of amortization based on the pattern
of discounted and undiscounted cash flows.
Year
1
2
3
4
5
Total
Net cash flows
undiscounted
Discounted cash
flows
Amortization –
undiscounted
Amortization –
discounted
Difference
Residual Value
20.0
18.2
15.2
20.0
16.5
15.2
18.2
(3.0)
16.5
(1.3)
20.0
15.0
15.2
15.0
0.2
20.0
13.7
15.2
13.7
1.5
20.0
100.0
12.4
15.0
12.4
2.6
75.8
75.8
75.8
0
ASC Topic 350-30-35-8
The amount of an intangible asset to be amortized shall be the amount initially
assigned to that asset less any residual value. The residual value of an intangible
asset shall be assumed to be zero unless at the end of its useful life to the entity
the asset is expected to continue to have a useful life to another entity and either
of the following conditions is met:
a. The reporting entity has a commitment from a third party to purchase the
asset at the end of its useful life.
b. The residual value can be determined by reference to an exchange
transaction in an existing market for that asset and that market is expected to
exist at the end of the asset’s useful life.
22.035 Residual value is the estimated fair value of an intangible asset at the end of its
useful life less any disposal costs. ASC Topic 350 presumes that an intangible asset’s
residual value is zero, absent an expectation that the intangible asset will have a useful
life to another entity after the acquirer finishes using it, and there is evidence to support
the nonzero residual value. Evidence would include either a purchase commitment from a
third party for the intangible asset or a market that exists currently that supports the
estimated residual value and is expected to exist at the end of the intangible asset’s useful
life to the current holder. Reliable evidence of a purchase commitment from a third party
would include the entity’s right to put the intangible asset to the third party, but would
not include call options held by the third party, rights of first refusal, or rights of first
offer.
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Reevaluation of Useful Life
ASC Paragraph 350-30-35-9
An entity shall evaluate the remaining useful life of an intangible asset that is
being amortized each reporting period to determine whether events and
circumstances warrant a revision to the remaining period of amortization. If the
estimate of an intangible asset’s remaining useful life is changed, the remaining
carrying amount of the intangible asset shall be amortized prospectively over that
revised remaining useful life.
ASC Paragraph 350-30-35-10
An intangible asset that initially is deemed to have a finite useful life shall cease
being amortized if it is subsequently determined to have an indefinite useful life,
for example, due to a change in legal requirements. If an intangible asset that is
being amortized is subsequently determined to have an indefinite useful life, the
asset shall be tested for impairment in accordance with [ASC] paragraphs 350-30-
35-18 through 35-20.
22.036 Useful lives of amortizable intangible assets are required to be reevaluated each
reporting period, with any changes in estimated useful lives accounted for prospectively
as a change in accounting estimate in accordance with ASC paragraph 250-10-45-17. The
change in accounting estimate should be accounted for in the period of change if the
change impacts that period only, or the period of change and future periods if the change
affects both. Financial statements of prior periods should not be restated or
retrospectively adjusted unless the change in estimate is a correction of an error. See
discussion of Adjustments to Provisional Amounts during the Measurement Period in
Section 10, Measurement Period.
22.037 An entity would stop amortizing an intangible asset prospectively that the entity
subsequently determines has an indefinite useful life. When amortization ceases for an
asset determined to have an indefinite life, the impairment test is carried out. Any
resulting impairment loss is accounted for as a change in estimate, not as a change in
accounting principle, and therefore would be presented in the same manner as other
impairment losses. ASC paragraph 350-30-35-11
22.038 For purposes of evaluating the amortization period, ASC Topic 350 is silent as to
whether the reference to reporting period is an annual period, an interim period, or both.
We believe it is consistent with other requirements in ASC Topic 350 to interpret the
reference to reporting period to mean annual reporting periods. Therefore, absent some
triggering event (e.g., change in intended use), we believe that an entity should reevaluate
the useful lives of intangible assets at least annually.
Impairment of Amortizable Intangible Assets
ASC Paragraph 350-30-35-14
An intangible asset that is subject to amortization shall be reviewed for
impairment in accordance with the Impairment or Disposal of Long-Lived Asset
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22. Goodwill and Other Intangible Assets
Subsections of [ASC] Subtopic 360-10 by applying the recognition and
measurement provisions in [ASC] paragraphs 360-10-35-17 through 35-35. In
accordance with the Impairment or Disposal of Long-Lived Asset Subsections of
[ASC] Subtopic 360-10, an impairment loss shall be recognized if the carrying
amount of an intangible asset is not recoverable and its carrying amount exceeds
its fair value. After an impairment loss is recognized, the adjusted carrying
amount of the intangible asset shall be its new accounting basis. Subsequent
reversal of a previously recognized impairment loss is prohibited.
22.039 ASC Section 360-10-35 requires a long-lived asset (asset group), including
amortizable intangible assets, to be tested for recoverability whenever events or changes
in circumstances (indicators) indicate that its carrying amount may not be recoverable
(trigger-based testing). In that case, the entity must evaluate whether the carrying amount
of the long-lived asset (asset group) is recoverable. If the carrying amount is not
recoverable, the entity determines whether there is an impairment loss by reference to the
fair value of the asset (asset group). Any impairment loss recognized under ASC Section
360-10-35 reduces the asset to its new cost basis. Reversal of a previously recognized
impairment loss is prohibited. ASC paragraph 350-30-35-14
22.040 See KPMG Handbook, Impairment of nonfinancial assets, for in-depth discussion
of the long-lived asset impairment model.
NONAMORTIZABLE INTANGIBLE ASSETS OTHER THAN GOODWILL
Indefinite-Lived Intangible Assets Are Not Amortized
ASC Paragraph 350-30-35-15
If an intangible asset is determined to have an indefinite useful life, it shall not be
amortized until its useful life is determined to be no longer indefinite.
ASC Paragraph 350-30-35-16
An entity shall evaluate the remaining useful life of an intangible asset that is not
being amortized each reporting period to determine whether events and
circumstances continue to support an indefinite useful life.
ASC Paragraph 350-30-35-17
If an intangible asset that is not being amortized is subsequently determined to
have a finite useful life, the asset shall be tested for impairment in accordance
with [ASC] paragraphs 350-30-35-18 through 35-19. That intangible asset shall
then be amortized prospectively over its estimated remaining useful life and
accounted for in the same manner as other intangible assets that are subject to
amortization.
ASC Paragraph 350-30-35-17A
Intangible assets acquired in a business combination or in an acquisition by a not-
for-profit entity that are used in research and development activities (regardless of
whether they have an alternative future use) shall be considered indefinite lived
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22. Goodwill and Other Intangible Assets
until the completion or abandonment of the associated research and development
efforts. During the period those assets are considered indefinite lived they shall
not be amortized but shall be tested for impairment in accordance with [ASC]
paragraphs 350-30-35-18 through 35-19. Once the research and development
efforts are completed or abandoned, the entity shall determine the useful life of
the assets based on the guidance in this Section. Consistent with the guidance in
[ASC] paragraph 360-10-35-49, intangible assets acquired in a business
combination or an acquisition by a not-for-profit entity that have been temporarily
idled shall not be accounted for as if abandoned.
22.041 Intangible assets with indefinite useful lives are not amortized. However, an entity
reevaluates its conclusion that an intangible asset has an indefinite useful life each
reporting period. If an intangible asset that is not being amortized is subsequently
determined to have a finite useful life, the intangible asset should be tested for
impairment in accordance with ASC paragraphs 350-30-35-18 through 35-19 and an
impairment loss should be recognized to the extent the carrying amount of the asset
exceeds its fair value. Thereafter, the intangible asset should be amortized prospectively,
based on its remaining useful life.
Intangible Assets Acquired in a Business Combination That Are Used in Research
and Development Activities
22.042 ASC Topic 805 specifies that assets acquired in a business combination that are
IPR&D are considered indefinite-lived intangible assets until completion or abandonment
of the related research and development efforts. Those assets are tested for impairment on
an annual basis in accordance with ASC Topic 350 as described below. Once the research
and development efforts are completed or abandoned, the entity determines whether the
asset continues to be indefinite-lived or has become a finite-lived asset. If finite-lived, the
useful lives of those intangible assets, if any, are estimated and the intangible asset is
amortized over the useful life, consistent with ASC paragraphs 350-30-35-6 through 35-
7.
22.043 When an IPR&D asset is intended to be used for defensive purposes, the
accounting treatment will depend on what the acquired IPR&D asset is intended to
defend. See Paragraph 12.018 for additional guidance.
Impairment of Identifiable Indefinite-Lived Intangible Assets
22.044 A nonamortizable intangible asset is tested annually for impairment and more
frequently if events or circumstances indicate that it is more likely than not that the asset
is impaired. An impairment loss is incurred when the carrying amount of the asset is
greater than its fair value; the excess is the impairment loss recognized. See KPMG
Handbook, Impairment of nonfinancial assets, for further discussion of the impairment
model.
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22. Goodwill and Other Intangible Assets
GOODWILL
22.045 Goodwill is not amortized; rather, it is tested at least annually for impairment at a
level referred to as a reporting unit. Goodwill must be tested between annual tests if an
event occurs or circumstances change to indicate that it is more likely than not that an
impairment loss has been incurred (i.e. a triggering event). Goodwill is considered
impaired and a loss may be recognized when the carrying amount of a reporting unit with
goodwill exceeds its fair value. See Section 26 for a discussion of a private company
accounting alternative for evaluating goodwill triggering events.
22.046 In January 2017, the FASB issued ASU 2017-04, Simplifying the Test for
Goodwill Impairment, which replaces the two-step impairment test for goodwill with a
one-step test that both identifies and measures goodwill impairment. Under the ASU, an
entity compares the fair value of the reporting unit to its carrying amount. If impairment
is identified, the entity would record that difference as an impairment loss. This
eliminates the previous requirement under Step 2 to perform a hypothetical purchase
price allocation to measure goodwill impairment.
22.047 The ASU is applied prospectively for annual and interim goodwill impairment
tests in fiscal years beginning after:
• December 15, 2019 for public business entities that file with the SEC,
excluding entities eligible to be smaller reporting companies as defined by the
SEC. The one-time determination of whether an entity is eligible to be a
smaller reporting company shall be based on an entity’s most recent
determination as of November 15, 2019, in accordance with SEC regulations.
• December 15, 2022 for all other entities.
Early adoption is permitted for goodwill impairment tests with a measurement date on or
after January 1, 2017. Once an entity has adopted ASU 2017-04, it must apply the one-
step approach to all goodwill impairment tests going forward. See Appendix A of KPMG
Handbook, Impairment of nonfinancial assets, for further discussion of the adoption of
ASU 2017-04.
22.048 A private company or not-for-profit entity can elect an accounting alternative to
amortize goodwill on a straight-line basis over ten years, or less than ten years if it can
demonstrate that a shorter useful life is more appropriate. An entity applying the
alternative is permitted to continue to test goodwill for impairment at the reporting unit
level or can test impairment prospectively at the entity level. See Section 26 for further
details on this goodwill amortization alternative.
22.049 When an entity disposes of a portion of a reporting unit constituting a business, a
relative fair value approach is used to assign a portion of reporting unit goodwill to the
portion being disposed of and that goodwill is written off. When only a portion of
goodwill is allocated to a business to be disposed of, the goodwill remaining in the
portion of the reporting unit to be retained should be tested for impairment.
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22. Goodwill and Other Intangible Assets
22.050 See KPMG Handbook, Impairment of Nonfinancial Assets, for in-depth
discussion of the subsequent accounting for goodwill, including the goodwill impairment
model, private company alternative and how to account for the disposition of all or a
portion of a reporting unit.
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Section 23 - The Tax Effects of Business
Combinations
See KPMG Handbook, Accounting for Income Taxes, Section 6, The Tax Effects of
Business Combinations.
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Section 24 - The Tax Effects of Changes
in Ownership Interests While Retaining
Control
See KPMG Handbook, Accounting for Income Taxes, Section 6, The Tax Effects of
Business Combinations.
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535
Section 25 - The Tax Effects of Asset
Acquisitions
See KPMG Handbook, Accounting for Incomes Taxes, Section 10, Other Considerations.
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Section 26 – Private Company and
Not-for-Profit Accounting Alternatives
Detailed Contents
Goodwill Accounting Alternatives
Amortization Alternative
Triggering Event Alternative
Identifiable Intangible Assets Accounting Alternative
Customer-Related Intangible Assets
Noncompete Agreements
Transition
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26. Private Company and Not-for-Profit Accounting Alternatives
26.000 ASC Subtopic 350-20, Intangibles—Goodwill and Other—Goodwill, provides a
goodwill amortization alternative to all entities other than public business entities, not-
for-profit entities, and employee benefit plans within the scope of Topics 960 through
965 (herein referred to as private companies). The amortization alternative allows an
eligible entity to:
• amortize goodwill on a straight-line basis over 10 years (or less than 10 years
if the entity demonstrates that a shorter useful life is more appropriate);
• make an accounting policy election to test goodwill for impairment at either
the entity or reporting unit level;
•
test goodwill for impairment only when a triggering event occurs that
indicates the fair value of an entity (or reporting unit) may be less than its
carrying amount (i.e., an annual impairment test is not required); and
• measure goodwill impairment, if any, as the excess of the entity’s (or
reporting unit’s) carrying amount over its fair value.
26.001 Subtopic 805-20, Business Combinations—Identifiable Assets and Liabilities, and
Any Noncontrolling Interest, provides private companies and not-for-profit entities an
alternative not to separately recognize and thereby subsume into goodwill any value
attributable to (a) customer-related intangible assets that are not capable of being sold or
licensed independently from the other business assets and (b) noncompete agreements
when applying the acquisition method for a business combination, assessing the nature of
the difference between the carrying amount of an investment and the amount of
underlying equity in net assets of an equity method investee, and adopting fresh-start
reporting when emerging from a Chapter 11 reorganization action. An entity that elects
the alternative under ASC Subtopic 805-20 also must adopt the goodwill alternative to
amortize goodwill. However, an entity that has adopted the alternative to amortize
goodwill is not required to adopt the alternative for intangible assets and noncompetition
agreements under ASC Subtopic 805-20.
26.001a In March 2021, the FASB issued ASU 2021-03, Accounting Alternative for
Evaluating Triggering Events, which provides private companies and not-for-profit
entities an alternative to:
•
identify and assess goodwill impairment triggering events only as of each
reporting date (interim or annual); and
• perform any necessary goodwill impairment test using the financial
information as of the reporting date (interim or annual).
Entities may apply the alternative to interim or annual financial statements that have not
yet been issued or made available for issuance as of March 30, 2021. See section 4.3.40
of KPMG Handbook, Impairment of nonfinancial assets for detailed discussion of this
goodwill accounting alternative.
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26. Private Company and Not-for-Profit Accounting Alternatives
26.002 While an entity may initially elect these alternatives at any time after the issuance
of the related standard without a preferability assessment, an entity should consider its
expected future eligibility to qualify for the accounting alternative(s) before adopting. For
example, an entity that is a private company now that becomes a public business entity in
the future (e.g., because its financial statements will be included in an SEC filing by
another entity, or it is itself filing a registration statement with the SEC) will need to
recast historical financial statements to comply with the requirements applicable to a
public business entity (i.e., as if the accounting alternative(s) had not been elected). The
SEC staff may not accept an assertion that recasting historical financial statements would
be impracticable, even though doing so may be difficult. Management of a private
company therefore should carefully consider whether it might take the company public in
the future before adopting the alternative accounting treatment for goodwill.
26.002a Before applying the accounting alternatives, an entity should evaluate if it is a
public business entity that cannot apply those alternatives. For example, entities meet the
definition of a public business entity if their financial statements are included in a
registrant's SEC filing, such as when the entity is a significant acquiree under Rule 3-05
of Regulation S-X, a significant equity method investee under Rule 3-09 of Regulation S-
X, or an equity method investee whose summarized financial information is included in a
registrant's SEC filing under Rule 4-08(g) of Regulation S-X.
26.002b If an entity is considered a public business entity due only to the inclusion of its
financial statements within another entity's SEC filing, the entity is considered a public
business entity only for the SEC filing. For its stand-alone financial statements used for
other purposes, the accounting alternatives can be elected. However, the definition of
public business entity is different from the definition used for public entities for pro
forma disclosures in Section 13 and close evaluation should be performed.
GOODWILL ACCOUNTING ALTERNATIVES
26.003 The Accounting Alternative Subsections of ASC Subtopic 350-20 provide private
companies and not-for-profit entities with accounting alternatives for the measurement of
goodwill after it is initially recognized.
AMORTIZATION ALTERNATIVE
26.004 A private company or not-for-profit entity that elects the goodwill amortization
alternative amortizes goodwill on a straight-line basis over ten years, or less than ten
years if it can demonstrate that a shorter useful life is more appropriate. An entity is not
required to justify a 10-year amortization period for goodwill, even if the primary asset(s)
acquired in the transaction is expected to generate cash flows for a period of less than 10
years.
26.005 Paragraph not used.
26.006 An entity applying the amortization alternative is permitted to continue to test
goodwill for impairment at the reporting unit level or can test impairment prospectively
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26. Private Company and Not-for-Profit Accounting Alternatives
at the entity level. An entity that makes a policy election to test goodwill for impairment
at the entity level does not need to demonstrate this policy election is preferable.
26.006a See chapter 11 of KPMG Handbook, Impairment of nonfinancial assets for
further discussion of the goodwill accounting alternative for amortizing goodwill.
TRIGGERING EVENT ALTERNATIVE
26.007 A private company or not-for-profit entity that elects the triggering event
alternative evaluates goodwill impairment triggering events only as of each reporting date
(interim or annual) and performs any necessary goodwill impairment test using the
financial information as of the reporting date (interim or annual). The accounting
alternative can be applied regardless of whether a private company or not-for-profit entity
has elected the goodwill amortization alternative. However, the triggering event
alternative does not allow eligible entities that report on an interim basis to only evaluate
goodwill triggering events as of the annual reporting date. Entities will need to carefully
evaluate their reporting requirements (e.g., terms of lending arrangements) to determine
whether their interim financial information is required to be in compliance with GAAP,
which could be the case even if that information is less than a full set of GAAP compliant
financial statements. See section 4.3.40 of KPMG Handbook, Impairment of nonfinancial
assets for detailed discussion of the goodwill accounting alternative for impairment
triggering event evaluation.
26.008 – 26.018 Paragraphs not used.
IDENTIFIABLE INTANGIBLE ASSETS ACCOUNTING
ALTERNATIVE
SCOPE
ASC Paragraph 805-20-15-2
A private company or not-for-profit entity may make an accounting policy
election to apply the accounting alternative in this Subtopic. The guidance in the
Accounting Alternative Subsections of this Subtopic applies when a private
company or not-for-profit entity is required to recognize or otherwise consider the
fair value of intangible assets as a result of any one of the following transactions:
a. Applying the acquisition method (as described in paragraph 805-10-05-4
for all entities and Subtopic 958-805 for additional guidance for not-for-profit
entities)
b. Assessing the nature of the difference between the carrying amount of an
investment and the amount of underlying equity in net assets of an investee
when applying the equity method of accounting in accordance with Topic 323
on investments—equity method and joint ventures
c. Adopting fresh-start reporting in accordance with Topic 852 on
reorganizations
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26. Private Company and Not-for-Profit Accounting Alternatives
ASC Paragraph 805-20-15-3
An entity that elects the accounting alternative shall apply all of the related
recognition requirements upon election. The accounting alternative, once elected,
shall be applied to all future transactions that are identified in paragraph 805-20-
15-2.
26.019 All the in-scope transactions identified in ASC paragraph 805-20-15-2 result in an
entity applying a new basis of accounting generally consistent with the acquisition
method. See Section 13 for discussion of The Acquisition Method. An entity that elects
the intangible asset accounting alternative must also adopt the goodwill accounting
alternative. However, an entity that has previously adopted the goodwill accounting
alternative is not required to adopt the intangible asset accounting alternative.
26.020 An entity that elects the alternative for in-scope transactions does not need to
justify that the use of the alternative is preferable as described in ASC paragraph 250-10-
45-2. See additional discussion in the Transition section.
RECOGNITION
ASC Paragraph 805-20-25-30
An intangible asset is identifiable if it meets either the separability criterion or the
contractual-legal criterion described in the definition of identifiable. However,
under the accounting alternative, an acquirer shall not recognize separately from
goodwill the following intangible assets:
a. Customer-related intangible assets unless they are capable of being sold or
licensed independently from other assets of a business
b. Noncompetition agreements.
CUSTOMER-RELATED INTANGIBLE ASSETS
26.021 Examples of customer-related intangible assets are discussed in ASC paragraphs
805-20-55-20 through 55-28 and include:
a. Customer lists
b. Order or production backlog
c. Customer contracts and related customer relationships
d. Noncontractual customer relationships
26.022 As discussed in ASC paragraphs 805-20-55-12 and 55-20 through 55-28,
customer lists and noncontractual customer relationships do not arise from contractual or
other legal rights, but may meet the separability criterion, and if so, are identifiable.
Order production backlog and customer contracts and related customer relationships arise
from contractual or other legal rights and therefore are identifiable without regard to
separability (i.e., they also may be separable, but separability is not a necessary condition
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26. Private Company and Not-for-Profit Accounting Alternatives
because they meet the contractual-legal criterion). See Section 7 for additional discussion
of the separability criterion, contractual-legal criterion, and customer-related intangibles.
26.023 ASC paragraph 805-20-25-31 provides examples of customer-related intangibles
that may meet the criterion for separate recognition under the intangible asset accounting
alternative including (but not limited to):
a. Mortgage servicing rights
b. Commodity supply contracts
c. Core deposits
d. Customer information (for example, names and contact information)
26.024 While the language in ASC paragraph 805-20-25-30(a) that identifies those
customer relationship intangibles that may NOT be subsumed into goodwill (i.e., those
that are “capable of being sold or licensed independently from other assets of a business”)
is different from the separability criterion discussed in ASC paragraph 805-20-55-3 (i.e.,
those that are “capable of being separated or divided from the acquiree and sold,
transferred, licensed, rented, or exchanged, either individually or together with a related
contract, identifiable asset, or liability”), we believe if a customer-related intangible asset
meets the separability criterion, it may also meet the standard for separate recognition
under the intangible asset accounting alternative (i.e., an entity will be unable to subsume
it into goodwill). However, entities should consider all relevant facts and circumstances
in determining whether a customer-related intangible does or does not meet the standard
for separate recognition. The standard in evaluating the alternative (similar to the
standard for evaluating the separability criterion) is whether a customer-related intangible
asset is capable of being sold or licensed independently, whether or not the entity has an
intention of selling the asset (see paragraph BC18 in the Basis for Conclusions to ASU
2014-18, Accounting for Identifiable Intangible Assets in a Business Combination).
26.025 ASC paragraph 805-20-25-31 states that many of the examples of customer-
related intangibles that require separate recognition also are contract-based intangible
assets; however, we do not believe that all contract-based intangibles are, by definition,
ineligible for the alternative (i.e., not all contract-based intangibles would necessarily
require separate accounting). For example, some contract-based intangibles have
contractual limitations on transfer, resulting in the holder being incapable of selling or
licensing them independently. Accordingly, to determine whether an intangible (contract-
based, or not) is eligible to be subsumed into goodwill, the entity will need to evaluate if
it is capable of being sold or licensed independently from other assets of a business. An
entity may not currently have a process in place to do that analysis on a contract-based
intangible, because the intangible would require separate accounting (absent the
intangible asset accounting alternative) even if it could not be sold because it meets the
contractual-legal criterion. We believe entities primarily will focus on whether the asset
is legally protected, separately transferable, and capable of providing discrete cash flows,
which are the attributes that the PCC and Board believe users consider the most relevant
in determining whether an intangible asset warrants separate accounting (see paragraph
BC29 in the Basis for Conclusions to ASU 2014-18).
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26. Private Company and Not-for-Profit Accounting Alternatives
26.026 In evaluating whether a customer-related intangible is capable of being sold or
licensed independently from other assets of a business, an entity should consider
contractual limitations on transfer (in a similar way limitations are considered in the
separability criterion analysis as discussed in ASC paragraph 805-20-55-4). The PCC and
the Board note in the Basis for Conclusions to ASU 2014-18 that the examples of
intangibles that require separate accounting represent relationships and information that
can often be sold without input from the customer or their agreement to the transfer.
Paragraph BC18 states that if the transfer depends on the decision of a customer, it would
be clear that the entity is not capable of selling that customer-related intangible asset
separately from the other assets of the business and therefore those intangible assets may
be eligible for the accounting alternative.
ASC Paragraph 805-20-25-32
Contract assets, as used in Topic 606 on revenue from contracts with customers,
are not considered to be customer-related intangible assets for purposes of
applying this accounting alternative. Therefore, contract assets are not eligible to
be subsumed into goodwill and shall be recognized separately.
26.027 Topic 606 defines a contract asset as:
An entity’s right to consideration in exchange for goods or services that the entity
has transferred to a customer when that right is conditioned on something other
than the passage of time (for example, the entity’s future performance).
Contract assets are reclassified to receivables once an entity has an unconditional right to
payment. Therefore, an acquired contract asset is recognized separately and does not
qualify for the accounting alternative.
ASC Paragraph 805-20-25-33
A lease is not considered to be a customer-related intangible asset for purposes of
applying this accounting alternative. Therefore, favorable and unfavorable leases
are not eligible to be subsumed into goodwill and shall be recognized separately.
26.028 Although ASC paragraph 805-20-25-33 does not specifically address the value
associated with leases in place at the acquisition date (in-place lease intangible assets) or
customer relationships associated with a lease, we believe that because a lease is
specifically identified as not being considered a customer-related intangible asset for the
purpose of applying the alternative, none of the identifiable intangible assets associated
with an acquired lease are eligible for the alternative and all would require separate
recognition. See Section 7 for additional discussion of intangibles arising from acquired
lease contracts.
26.029 While favorable lease contracts are not eligible for the alternative, paragraph
BC20 in the Basis for Conclusions of ASU 2014-18 states that other favorable customer
contracts are eligible to be subsumed into goodwill. However, an entity will need to
evaluate whether the favorable contract is capable of being sold or licensed independently
from other assets of a business, and, if so, it must be recognized separately from
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26. Private Company and Not-for-Profit Accounting Alternatives
goodwill. Unfavorable customer contracts (or other intangible liabilities recognized as
result of below-market terms) are not eligible for the alternative as they are not intangible
assets (i.e., offsetting of customer-related intangible liabilities against customer-related
assets is not permitted).
NONCOMPETE AGREEMENTS
26.030 Section 7 describes noncompete agreements as:
Agreements that place restrictions on a person’s or a business’ ability to compete
with another entity and, as such, meet the contractual-legal criterion for
recognition as intangible assets. The restrictions generally relate to specified
markets and/or specified products or activities for some period of time. These
agreements may be entered into on a stand-alone basis, or may be embedded in
another agreement, such as an acquisition agreement or an employment contract.
26.031 The PCC and the Board stated in the Basis for Conclusions to ASU 2014-18 that
an entity is not required to assess whether a noncompete agreement is capable of being
sold or licensed separately from the other assets of the business and that noncompete
agreements would seldom, if ever, meet the criteria for recognition.
26.032 We understand (and the Basis for Conclusions acknowledges in paragraph BC19)
that some entities consider noncompete agreements part of the business combination and
some do not (i.e., they represent transactions separate from the business combination)
because noncompete agreements are not specifically addressed in the business
combinations guidance. The PCC and Board decided not to provide additional guidance
on this issue. Entities that do not account for noncompete agreements in applying
acquisition accounting will not be affected by the alternative.
26.033 See Section 7 for additional discussion of noncompete agreements.
ASC Paragraph 805-20-15-4
An entity that elects this accounting alternative must adopt the accounting
alternative for amortizing goodwill in the Accounting Alternatives Subsections of
[ASC] Topic 350-20 on intangibles—goodwill and other. If the accounting
alternative for amortizing goodwill was not adopted previously, it should be
adopted on a prospective basis as of the adoption of the accounting alternative in
[ASC] Subtopic [805-20]. For example, upon adoption, existing goodwill should
be amortized on a straight-line basis over 10 years, or less than 10 years if the
entity demonstrates that another useful life is more appropriate. However, an
entity that elects the accounting alternative for amortizing goodwill is not required
to adopt the accounting alternative in [ASC] Subtopic [805-20].
26.034 If the intangible asset accounting alternative is elected, an entity also is required
to adopt the accounting alternative for amortizing goodwill, in which case goodwill
resulting from a business combination is amortized on a straight-line basis over a period
of 10 years. An entity also may amortize its goodwill over a shorter period if it can
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26. Private Company and Not-for-Profit Accounting Alternatives
demonstrate that another useful life is more appropriate, which may be the case when
goodwill consists of a significant amount of customer-related intangibles and/or
noncompete agreements for which the intangible asset accounting alternative has been
applied. See KPMG Handbook, Impairment of nonfinancial assets, for an additional
discussion of the goodwill alternative.
TRANSITION
ASC Paragraph 805-20-65-2
The following represents the transition information related to Accounting
Standards Updates No. 2014-18, Business Combinations (Topic 805): Accounting
for Identifiable Intangible Assets in a Business Combination, and No. 2019-06,
Intangibles—Goodwill and Other (Topic 350), Business Combinations (Topic
805), and Not-for-Profit Entities (Topic 958): Extending the Private Company
Accounting Alternatives on Goodwill and Certain Identifiable Assets to Not-for-
Profit Entities, referenced in [ASC] paragraph 805-20-15-1A:
a. Upon adoption of the Accounting Alternative Subsections of this Subtopic,
that guidance shall be effective prospectively to the first transaction that is
identified in [ASC] paragraph 805-20-15-2 after the adoption of the
accounting alternative.
b. Customer-related intangible assets and noncompetition agreements that
exist as of the beginning of the period of adoption shall continue to be
subsequently measured in accordance with [ASC] Topic 350 on intangibles—
goodwill and other. That is, existing customer-related intangible assets and
noncompetition agreements should not be subsumed into goodwill upon
adoption of the Accounting Alternative Subsections of this Subtopic.
c. Subparagraph superseded by Accounting Standards Update No. 2016-03.
d. A private company or not-for-profit entity that makes an accounting policy
election to apply the guidance in the Accounting Alternative Subsections of
this Subtopic for the first time need not justify that the use of the accounting
alternative is preferable as described in [ASC] paragraph 250-10-45-2.
26.035 If elected, the identifiable asset accounting alternative is applied on the
occurrence of the first in-scope transaction after the adoption of the accounting
alternative and to all subsequent transactions thereafter and retrospective application is
not permitted (only new customer-related intangible assets and noncompete agreements
arising from transactions after the adoption date are eligible for the accounting
alternative). An entity does not need to make a preferability assessment on the initial
election of the intangible asset accounting alternative. See chapter 11 of KPMG
Handbook, Impairment of nonfinancial assets, for transition guidance related to the
goodwill alternative.
26.036 Based on discussions with the FASB staff, under the transition guidance we
believe an entity has flexibility in defining its adoption period as its annual or an interim
reporting period (including an interim period other than the first quarter) as long as the
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26. Private Company and Not-for-Profit Accounting Alternatives
financial statements for that period have not yet been made available for issuance. Once
an entity elects its adoption period, the beginning of that fiscal year will become the date
on which goodwill amortization will begin for existing elements of goodwill (as
discussed in Paragraph 26.015).
26.037 For example, assume a calendar year entity completed business combinations in
September 2016 and October 2016 and issued September 30, 2016 interim financial
statements. We believe the entity will have two options for initial adoption of the
accounting alternatives. The first option would be for the entity to define its period of
adoption as its annual 2016 reporting period, which is permitted because the annual 2016
financial statements have not yet been made available for issuance. Under that approach,
the entity would apply the intangible asset accounting alternative to its entire annual
period including both the September 2016 and October 2016 business combinations
(because the September 2016 transaction was the first in-scope transaction in the annual
period of adoption and the alternative is applied prospectively to all subsequent in-scope
transactions). The entity also would amortize existing goodwill for the entire 2016 annual
period (i.e., begin amortizing as of January 1, 2016).
26.038 A second option would be for the entity to define its period of adoption as the
fourth quarter of 2016, which is permitted because the fourth quarter 2016 financial
statements have not yet been made available for issuance. Under that approach, the entity
would apply the intangible asset accounting alternative only to its October 2016 business
combination. In this situation, the entity's annual 2016 financial statements would reflect
the September 2016 business combination being accounted for without the intangible
asset accounting alternative applied and the October 2016 business combination with the
intangible asset accounting alternative applied. Although the period of adoption is the
fourth quarter, goodwill amortization would begin at the beginning of the fiscal year
(January 1, 2016) for goodwill that existed on that date. Goodwill amortization would
begin in September 2016 for goodwill recognized in connection with the September 2016
business combination and in October 2016 for goodwill recognized in connection with
the October 2016 business combination. Under that approach, the entity would not be
able to apply the intangible asset accounting alternative to the September 2016
transaction because financial statements for that period (i.e., the third quarter of 2016)
had already been available for issuance. The entity would most likely use this adoption
option when it has already finalized (or nearly finalized) its acquisition accounting for the
September 2016 business combination and does not want to incur the cost to revise its
acquisition accounting for that transaction for the purposes of its annual financial
statements.
26.039 We believe the intangible asset accounting alternative may only be adopted for
transactions occurring during periods for which financial statements have not been issued
(or made available for issuance). For example, assume an entity completed a business
combination in December 2015 and issued the 2015 financial statements indicating the
acquisition accounting was provisional. That entity would not be able to apply the
intangible asset accounting alternative to that December 2015 transaction on the basis
that the acquisition accounting was not finalized until 2016. The fact that acquisition
accounting was provisional in the previously-issued financial statements is not a factor in
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26. Private Company and Not-for-Profit Accounting Alternatives
determining that transaction's eligibility for the intangible asset accounting alternative
because ASC paragraph 805-20-15-2 speaks specifically about applying the guidance in
the period when it is required to recognize the fair value of intangible assets for an in-
scope transaction (e.g., the acquisition date) rather than the period in which the
accounting for that transaction is completed.
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Section 27 - Application of Pushdown
Accounting
Detailed Contents
Background
When and How to Apply Pushdown Accounting
Recognition
Example 27.1: Pushdown to Subsidiaries of an Acquired Entity
Determining Whether a Change-in-Control Event Has Occurred
Transaction Costs
Accounting for Goodwill
Treatment of Bargain Purchase Gains
Accounting for Acquisition-Related Liabilities
Effective Date
How to Apply the New Standard
Example 27.2: Acquisition of Less Than a Majority of Outstanding Stock
Example 27.3: Effect of a Call Option
Example 27.4: Applying Pushdown Accounting
Financial Statement Presentation
Example 27.5: Financial Statement Presentation
Accounting Policies
Presentation of Contingent Expenses of the Acquiree
Acquisition-Related Debt
Example 27.6: Joint and Several Obligation
Acquisition-Related Goodwill
Example 27.7: Goodwill Allocation
Acquiree with Foreign Entities
Acquisition Costs
Contingent Consideration
Electing Fair Value Option
Application of Pushdown Accounting at a Later Date
Example 27.8: Change in Accounting Principle
Example 27.9: Rolling Forward Subsequent Activity
Forgoing the Election to Apply Pushdown Accounting
Management Responsibilities for ICOFR
Acquirer’s Consolidated Financial Statements
Acquiree Separate Financial Statements
Change in Tax Basis
SEC and Call Report Considerations
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27. Application of Pushdown Accounting
27.000 An acquired entity is allowed, but not required, to apply pushdown accounting
upon acquisition by a new controlling parent. The FASB provides specific guidance on
how to account for goodwill, bargain purchase gains, and acquisition-related liabilities in
the acquired entity’s financial statements.
ASC Paragraph 805-50-25-4
An acquiree shall have the option to apply pushdown accounting in its separate
financial statements when an acquirer—an entity or individual—obtains control
of the acquiree. An acquirer might obtain control of an acquiree in a variety of
ways, including any of the following:
a. By transferring cash or other assets
b. By incurring liabilities
c. By issuing equity interests
d. By providing more than one type of consideration
e. Without transferring consideration, including by contract alone as discussed
in paragraph 805-10-25-11.
ASC Paragraph 805-50-25-6
The option to apply pushdown accounting may be elected each time there is a
change-in-control event in which an acquirer obtains control of the acquiree. An
acquiree shall make an election to apply pushdown accounting before the
financial statements are issued (for a Securities and Exchange Commission (SEC)
filer and a conduit bond obligor for conduit debt securities that are traded in a
public market) or the financial statements are available to be issued (for all other
entities) for the reporting period in which the change-in-control event occurred. If
the acquiree elects the option to apply pushdown accounting, it must apply the
accounting as of the acquisition date.
ASC Paragraph 805-50-25-8
Any subsidiary of an acquiree also is eligible to make an election to apply
pushdown accounting to its separate financial statements in accordance with the
guidance in paragraphs 805-50-25-4 through 25-7 irrespective of whether the
acquiree elects to apply pushdown accounting.
ASC Paragraph 805-50-25-9
The decision to apply pushdown accounting to a specific change-in control event
if elected by an acquiree is irrevocable.
27.001 The election to apply pushdown accounting may be made by the acquired entity
in the period in which there is a new controlling parent. However, once pushdown
accounting is elected, it is irrevocable. The election to apply pushdown accounting can be
made separately for each change-in-control event. Additionally, the acquired entity’s
subsidiaries can choose to apply pushdown accounting whether or not the acquired entity
does.
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27. Application of Pushdown Accounting
BACKGROUND
27.002 Pushdown accounting refers to establishing a new basis of accounting in the
separate financial statements of the acquired entity (or acquiree) after it is acquired. The
acquisition adjustments recorded by the acquirer in a business combination under ASC
Topic 805 are pushed down to the acquiree’s separate financial statements.
27.003 Before the FASB issued ASU 2014-17, Pushdown Accounting, U.S. GAAP
provided limited guidance for determining when, if ever, pushdown accounting should be
applied. If non-SEC registrants considered applying pushdown accounting, they generally
looked to the SEC guidance. Additionally, pushdown accounting was generally not
required when the acquiree had public debt or preferred stock outstanding.
Rescinded SEC Guidance on Pushdown Accounting
Purchase transaction
Application of pushdown accounting
An acquisition of more than 95% of an
entity*
Generally required
An acquisition of between 80% and 95%
of an entity (inclusive)*
Permitted
An acquisition of less than 80% of an
entity*
Generally prohibited
*Under the new standard, pushdown accounting is permitted but not required upon
acquisition by a new controlling parent.
WHEN AND HOW TO APPLY PUSHDOWN ACCOUNTING
27.004 The acquirer does not need to apply acquisition accounting to enable the acquiree
to elect pushdown accounting, although that may be one of the factors the acquiree
considers when evaluating the benefits and costs. For example, if the acquirer was an
investment company or individual, it may not be required to apply acquisition
accounting. However, the acquiree would be able to elect to apply pushdown accounting
if the acquirer is a new controlling parent.
27.005 Transactions including, but not limited to, the formation of a joint venture,
combinations of entities under common control, and certain other transactions that are
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27. Application of Pushdown Accounting
identified in ASC paragraph 805-10-15-4 are not within the scope of the standard because
they do not fall under the scope of business combinations accounting.
27.006 ASU 2014-17 provides guidance on pushdown accounting for both public and
nonpublic entities that are a business or nonprofit activity upon a change-in-control event.
Previously, some non-SEC registrants applied the SEC’s guidance by analogy to
determine whether and at what level to apply pushdown accounting. Now the standard
simplifies when pushdown accounting may be applied because it specifies that it can be
used by both public and nonpublic entities when there is a change-in-control event.
27.006a Additionally, we believe a subsidiary can elect to apply pushdown accounting in
its separate financial statements when the parent entity emerges from bankruptcy and
applies fresh-start reporting under ASC Topic 852, Reorganizations. This is the case even
if the subsidiary did not file for bankruptcy.
RECOGNITION
27.007 An acquired entity has the option to apply pushdown accounting in its separate
financial statements upon acquisition by a new controlling parent. An acquirer might
obtain control of an acquiree in a number of ways including:
• Transferring cash or other assets;
•
•
Incurring liabilities;
Issuing equity interests;
• Providing more than one type of consideration; and
• Without transferring consideration, including by contract alone as discussed in
ASC Topic 805.
27.008 An acquired entity may make the election to apply pushdown accounting each
time it is acquired by a new controlling parent. Once an entity elects to apply pushdown
accounting to a specific change-in-control event, that decision is irrevocable.
27.009 A consolidated subsidiary of an acquired parent also has the option to apply
pushdown accounting in its separate financial statements irrespective of whether the
acquired parent applies pushdown accounting in its consolidated financial statements.
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27. Application of Pushdown Accounting
Example 27.1: Pushdown to Subsidiaries of an Acquired Entity
Entity A (Acquirer) acquires 80% of Entity B
(acquired parent) and its wholly owned subsidiary
Entity C (acquired subsidiary).
After considering the informational needs of its
separate financial statement users, Entity B chooses
not to apply pushdown accounting.
Entity C performs a similar evaluation as Entity B
and elects to apply pushdown accounting. Its new
basis is consistent with that established by Entity A
even though Entity B did not apply pushdown
accounting.
For purposes of Entity B’s separate consolidated
financial statements, Entity C’s financial
information would be based on Entity C’s historical
information (not pushdown information) even
though Entity C applies pushdown accounting in its
separate financial statements.
ASC Paragraph 805-50-25-5
The guidance in the General Subsections of [ASC] Subtopic 810-10 on
consolidation, related to determining the existence of a controlling financial
interest shall be used to identify the acquirer. If a business combination has
occurred but applying that guidance does not clearly indicate which of the
combining entities is the acquirer, the factors in [ASC] paragraphs 805-10-55-11
through 55-15 shall be considered in identifying the acquirer. However, if the
acquiree is a variable interest entity (VIE), the primary beneficiary of the acquiree
always is the acquirer. The determination of which party, if any is the primary
beneficiary of a VIE shall be made in accordance with the guidance in the
Variable Interest Entities Subsections of [ASC] Subtopic 810-10, not by applying
the guidance in the General Subsections of that Subtopic related to a controlling
financial interest or the guidance in [ASC] paragraphs 805-10-55-11 through 55-
15.
27.010 ASC paragraph 805-50-25-5 uses the definition of control used in the
consolidation guidance in ASC Subtopic 810-10. This Subtopic indicates that a
controlling financial interest generally results from one entity obtaining, either directly or
indirectly, more than 50% of the outstanding shares of another entity. In some instances,
the power to control an entity may exist at a lesser percentage of ownership or from other
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27. Application of Pushdown Accounting
means (e.g., through a contractual arrangement or as the primary beneficiary of a variable
interest entity).
27.011 The EITF and FASB considered whether consolidated subsidiaries of an acquired
parent that elected pushdown accounting must make the same election. The EITF and
FASB ultimately concluded that each entity in the acquired consolidated group could
decide whether to apply pushdown accounting in its separate financial statements because
different entities within the group may have different financial statement users with
different information needs.
DETERMINING WHETHER A CHANGE-IN-CONTROL EVENT HAS OCCURRED
27.012 Consolidation guidance generally is used to identify whether control has changed.
In situations where a business combination has occurred but applying the guidance in
ASC Subtopic 810-10 does not clearly indicate which of the combining entities is the
acquirer, ASC paragraphs 805-10-55-11 through 55-15 should be considered to
determine which entity is the acquirer (see Paragraphs 4.004 - 4.022). If the acquiree is a
variable interest entity, the primary beneficiary of the acquiree, as determined by ASC
Subtopic 810-10, always is considered the acquirer. See SEC and Call Report
Considerations for more information.
Initial Measurement
ASC Paragraph 805-50-30-10
If an acquiree elects the option in [ASC] Subtopic [805-50] to apply pushdown
accounting, the acquiree shall reflect in its separate financial statements the new
basis of accounting established by the acquirer for the individual assets and
liabilities of the acquiree by applying the guidance in other Subtopics of [ASC]
Topic 805. If the acquirer did not establish a new basis of accounting for the
individual asset and liabilities of the acquiree because it was not required to apply
[ASC] Topic 805 (for example, if the acquirer was an individual or an investment
company -- see [ASC] Topic 946 on investment companies), the acquiree shall
reflect in its separate financial statements the new basis of accounting that would
have been established by the acquirer had the acquirer applied the guidance in
other Subtopics of [ASC] Topic 805.
ASC Paragraph 805-50-30-11
An acquiree shall recognize goodwill that arises because of the application of
pushdown accounting in its separate financial statements. However, bargain
purchase gains recognized by the acquirer, if any, shall not be recognized in the
acquiree’s income statement. The acquiree shall recognize the bargain purchase
gains recognized by the acquirer as an adjustment to additional paid-in capital (or
net assets of a not-for-profit acquiree).
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27. Application of Pushdown Accounting
ASC Paragraph 805-50-30-12
An acquiree shall recognize in its separate financial statements any acquisition-
related liability incurred by the acquirer only if the liability represents an
obligation of the acquiree in accordance with other applicable Topics.
27.013 An entity that elects to apply pushdown accounting in its separate financial
statements on a change-in-control event will reflect the new basis of accounting
established by the acquirer for the individual assets and liabilities of the acquired entity
by applying ASC Topic 805. Additionally, if pushdown accounting is elected, an entity is
required to disclose sufficient information to enable financial statement users to evaluate
the nature and effect of pushdown accounting.
27.014 If the acquirer does not apply ASC Topic 805 for the assets and liabilities of the
acquiree (e.g., if the acquirer is an individual or an investment company), the acquiree
may still elect pushdown accounting by applying the new basis in its separate financial
statements consistent with what would have been the acquirer’s basis if it had applied
ASC Topic 805.
27.015 In applying pushdown accounting, the carrying amounts of the assets and
liabilities in the financial statements of the acquired entity are adjusted to reflect the
acquisition accounting adjustments recorded (or that would have been recorded) in the
consolidated financial statements of the acquiring entity as of the date control was
obtained. If pushdown accounting is applied, the separate financial statements of the
acquired entity must reflect all of the acquisition adjustments; partial pushdown
accounting is not permitted.
TRANSACTION COSTS
27.016 Transaction costs incurred by the acquirer are not part of the new basis of the
acquired entity. Therefore, the acquirer’s transaction costs are not pushed down to the
separate financial statements of the acquired entity.
ACCOUNTING FOR GOODWILL
27.017 If the acquiree elects to apply pushdown accounting, goodwill arising from the
application of ASC Topic 805 is recorded in the separate financial statements of the
acquiree. The amount of parent goodwill pushed down to the acquiree may be different
from the amount of goodwill assigned to the parent’s reporting units that include the
acquiree, because the parent may assign some of the acquiree’s goodwill to other parent
reporting units that may benefit from the acquisition. See the section on Acquisition-
Related Goodwill for more information.
TREATMENT OF BARGAIN PURCHASE GAINS
27.018 A bargain purchase gain, if any, recognized by the acquirer that results from the
application of ASC Topic 805 is not recorded in the income statement of the acquiree
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27. Application of Pushdown Accounting
when the acquiree elects to apply pushdown accounting. The acquiree recognizes a
bargain purchase gain as an adjustment to additional paid-in capital (or net assets of a
not-for-profit acquiree) in its separate financial statements.
ACCOUNTING FOR ACQUISITION-RELATED LIABILITIES
27.019 Acquisition-related liabilities, including debt incurred by an acquirer, is
recognized in the separate financial statements of the acquired entity only if that entity is
required to do so under other U.S. GAAP (e.g., if the entity is a named obligor or if it
meets the requirements of joint and several liability arrangements).
27.020 When determining how to treat acquisition-related liabilities, the EITF and FASB
considered the definition of a liability in FASB Concepts Statement No. 6 that states,
“Liabilities are probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other entities in
the future as a result of past transactions or events.” Therefore, the EITF and FASB
concluded that an acquired entity would recognize a liability incurred by the acquirer
only if that obligation is the acquired entity’s liability.
Subsequent Measurement
ASC Paragraph 805-50-35-2
An acquiree shall follow the subsequent measurement guidance in other Subtopics
of [ASC] Topic 805 and other applicable Topics to subsequently measure and
account for its assets, liabilities, and equity instruments, as applicable.
27.021 If an acquiree elects to apply pushdown accounting in its separate financial
statements, in subsequent reporting periods it would follow the subsequent measurement
guidance in ASC Topic 805. This topic addresses items such as reacquired rights,
indemnification assets, and contingent consideration. Guidance on how to subsequently
measure goodwill and other intangible assets is provided in ASC Topic 350.
Disclosures
ASC Paragraph 805-50-50-5
If an acquiree elects the option to apply pushdown accounting in its separate
financial statements, it shall disclose information in the period in which pushdown
accounting was applied (or in the current reporting period if the acquiree
recognizes adjustments that relate to pushdown accounting) that enables users of
financial statements to evaluate the effect of pushdown accounting. To meet this
disclosure objective, the acquiree shall consider the disclosure requirements of
other Subtopics of [ASC] Topic 805.
ASC Paragraph 805-50-50-6
Information to evaluate the effect of pushdown accounting may include the
following:
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27. Application of Pushdown Accounting
a. The name and a description of the acquirer and a description of how the
acquirer obtained control of the acquiree.
b. The acquisition date.
c. The acquisition-date fair value of the total consideration transferred by the
acquirer.
d. The amounts recognized by the acquiree as of the acquisition date for each
major class of assets and liabilities as a result of applying pushdown
accounting. If the initial accounting for pushdown accounting is incomplete
for any amounts recognized by the acquiree, the reasons why the initial
accounting is incomplete.
e. A qualitative description of the factors that make up the goodwill
recognized, such as expected synergies from combining operations of the
acquiree and the acquirer, or intangible asserts that do not qualify for separate
recognition, or other factors. In a bargain purchase (see [ASC] paragraphs
805-30-25-2 through 25-4), the amount of the bargain purchase recognized in
additional paid-in capital (or net assets of a not-for-profit acquiree) and a
description of the reasons why the transaction results in a gain.
f. Information to evaluate the financial effects of adjustments recognized in
the current reporting period that relate to pushdown accounting that occurred
in the current or previous periods (including those adjustments made as a
result of the initial accounting for pushdown accounting being incomplete [see
[ASC] paragraphs 805-10-25-13 through 25-14]).
The information in this paragraph is not an exhaustive list of disclosure
requirements. The acquiree shall disclose whatever additional information is
necessary to meet the disclosure objective set out in [ASC] paragraph 805-50-50-
5.
27.022 An acquiree that elects to apply pushdown accounting in its separate financial
statements must disclose, in the period in which pushdown accounting was applied (or in
the reporting period in which a pushdown adjustment was recorded by the acquiree),
sufficient information to enable financial statement users to evaluate the effect of
applying pushdown accounting. Accordingly, the acquiree should consider the
disclosures in other Subtopics of ASC Topic 805. ASC paragraph 805-50-50-6 indicates
that these disclosures may include:
• The name and a description of the acquirer and a description of how the
acquirer obtained control of the acquiree.
• The acquisition date.
• The acquisition-date fair value of the total consideration transferred by the
acquirer.
• The amounts recognized by the acquiree as of the acquisition date for each
major class of assets and liabilities as a result of applying pushdown
accounting. If the initial pushdown accounting is incomplete for any amounts
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27. Application of Pushdown Accounting
recognized by the acquiree, the reasons why the initial accounting is
incomplete.
• A qualitative description of the factors that make up the goodwill recognized,
including expected synergies from combining operations of the acquiree,
intangible assets that do not qualify for separate recognition, or other factors.
In a bargain purchase, the amount recognized in additional paid-in-capital (or
net assets of a not-for-profit acquiree) and a description of the reasons why the
transaction resulted in a gain.
•
Information to evaluate the financial effects of adjustments recognized in the
current reporting period that relate to pushdown accounting that occurred in
the current or previous reporting periods (including those adjustments made as
a result of the initial pushdown accounting being incomplete).
27.023 The disclosures listed above are not an all-inclusive list of the disclosure
requirements. The acquiree is required to disclose enough information to meet the
disclosure objectives of ASC Subtopic 805-50.
27.024 The EITF decided that when an entity elects pushdown accounting, it must make
sufficient disclosures to enable financial statement users to evaluate the nature and effect
of pushdown accounting. An acquired entity does not need to disclose information about
its decision not to apply pushdown accounting.
27.025 The disclosure requirements for entities that apply pushdown accounting are
generally consistent with the disclosure requirements for entities applying business
combination accounting.
EFFECTIVE DATE
27.026 The new standard may be applied by an acquirer to a change-in-control event
occurring:
• On or after November 18, 2014; or
• Before November 18, 2014, if the financial statements for the period of the
change-in-control event have not been issued (i.e., an SEC filer or a conduit
bond obligor) or made available to be issued (all other entities).
27.027 Subsequent to November 18, 2014, the new standard also may be applied by an
acquiree as of the acquisition date of its most recent change-in-control event as a change
in accounting principle under ASC Topic 250 if:
• The acquisition date of the change-in-control event is before November 18,
2014, and
• The financial statements of the reporting period that includes the acquisition
date have been issued (an SEC filer or a conduit bond obligor).
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27. Application of Pushdown Accounting
See Application of Pushdown Accounting at a Later Date for additional information.
27.028 Pushdown accounting, including pushdown of debt under SAB Topic 5.J, that has
been applied by an acquiree prior to the effective date of the new standard is irrevocable.
HOW TO APPLY THE NEW STANDARD
27.029 Under pushdown accounting, the carrying amounts of the assets and liabilities in
the financial statements of the acquiree are adjusted to reflect the acquisition adjustments
recorded in the consolidated financial statements of the acquiring entity as of the date
control was obtained. The separate financial statements of the acquiree must reflect all of
the acquisition adjustments; partial pushdown accounting is not permitted.
27.030 In pushdown accounting, the acquired entity is considered a new reporting entity
for accounting purposes. The retained earnings of the acquiree are eliminated and the net
effect of the pushdown adjustments is recognized as an adjustment to each of the affected
capital accounts attributable to common shareholders. When the acquiring entity acquires
100% of the outstanding common stock of the acquiree, the equity (i.e., capital stock and
additional paid-in capital) of the acquiree after the application of pushdown accounting
will generally equal the purchase price. However, if the acquiree recognizes a portion of
the parent’s debt associated with the acquisition, either because it is jointly and severally
liable or it is the legal obligor, the acquiree’s equity would not equal the purchase price.
Additionally, if the parent entity recorded a bargain purchase gain because the purchase
price was less than the acquired entity’s fair value, the equity of the acquiree, after the
application of pushdown accounting, will equal the purchase price plus the bargain
purchase gain. The bargain purchase gain is not recognized in the acquiree’s stand-alone
financial statements.
Example 27.2: Acquisition of Less Than a Majority of Outstanding Stock
Assume that upon the acquisition of 40% of the outstanding stock of an entity that is
not a VIE the buyer obtains control over the entity as defined in ASC Topic 810.
Control is generally obtained when one entity obtains, either directly or indirectly,
more than 50% of the outstanding shares of another entity. In some instances the
power to control an entity may exist at a lesser percentage of ownership.
Although the buyer acquires less than a majority of the outstanding stock, the entity
may elect to apply pushdown accounting because the acquisition of 40% of the stock
was a change-in-control event.
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27. Application of Pushdown Accounting
Example 27.3: Effect of a Call Option
In 20X4, Bank A acquires an interest of 48% of Bank B’s common stock from a third
party. Bank A also acquires a call option to purchase an additional 20% of Bank B’s
common stock from the third party in two years at the same price per share. Assume
that Bank B is not a VIE and that the transaction does not give Bank A control over
Bank B. Therefore, Bank B may not elect to apply pushdown accounting in 20X4
because there is no change-in-control event, because Bank A’s 48% ownership and
call option does not give it control over Bank B.
On exercise of the call option, Bank A’s ownership will increase to 68% interest of the
common stock. Assume that the exercise of the call option gives Bank A control over
Bank B, which is still not a VIE. Therefore, at the time of that change-in-control
event, Bank B may elect to apply pushdown accounting in its separate financial
statements when Bank A becomes the new controlling parent through the exercise of
the call.
Example 27.4: Applying Pushdown Accounting
ABC Corp. acquires all of the outstanding common stock of DEF Corp. for $1,000.
ABC accounts for the acquisition as a business combination under ASC Topic 805.
DEF elects to apply pushdown accounting in its separate financial statements.
As of the date of the acquisition, the book value of DEF's net assets is $650. DEF's
equity accounts reflect common stock of $100, additional paid-in capital of $200, and
retained earnings of $350.
The fair value of DEF’s identifiable net assets acquired is $800. Therefore, $200 is
allocated to goodwill ($1,000 purchase price less the $800 fair value of identifiable net
assets).
DEF records the following entry to record the pushdown accounting adjustments.
Identifiable net assets
Goodwill
Retained earnings
Additional paid-in capital
$150
200
350
$700
DEF's financial statements before and after applying pushdown accounting as of the
date of the acquisition reflect the following:
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27. Application of Pushdown Accounting
Before Pushdown
After Pushdown
Identifiable net assets
Goodwill
Total net assets
Common stock
Additional paid-in capital
Retained earnings
Total equity
$ 650
—
$ 650
100
200
350
$ 650
$ 800
200
$1,000
100
900
—
$1,000
FINANCIAL STATEMENT PRESENTATION
27.031 The application of pushdown accounting represents a termination of one basis of
accounting and the creation of a new basis. Therefore, the acquiree should not combine
the periods prior to and subsequent to the date that pushdown accounting is applied. To
emphasize the change in accounting basis, a vertical line generally separates the
predecessor and successor financial statement periods if those periods are presented
together. The financial statements would also clearly describe the basis of presentation as
a result of applying pushdown accounting.
Example 27.5: Financial Statement Presentation
Parent acquires ABC Corp. on March 31, 20X5, and ABC applies pushdown
accounting on that date. If ABC presents both the predecessor and successor periods
in its financial statements, ABC’s December 31, 20X5 statements of income,
comprehensive income, cash flows, and changes in shareholder’s equity would
include a 3-month predecessor period and a 9-month successor period separated by a
vertical line. The columns related to the two accounting entities would generally be
labeled Predecessor and Successor or a similar designation. The notes to the financial
statements would include relevant information for the predecessor and successor
periods.
The following illustrates the format of columns for ABC’s statement of income for the
predecessor and successor periods:
Successor
Predecessor
April 1 – December
31, 20X5
January 1 - March
31, 20X5
Net income (loss)
$XX
$XX
Predecessor
20X4
$XX
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27. Application of Pushdown Accounting
ACCOUNTING POLICIES
27.031a ASC paragraph 805-50-35-2 states that an acquiree shall follow the subsequent
measurement guidance in ASC Topic 805 and other applicable Topics to subsequently
measure and account for its assets, liabilities and equity instruments, as applicable. In a
business combination, an acquirer classifies and designates the identifiable assets
acquired and liabilities assumed based on the acquirer’s accounting policies as they exist
on the date of acquisition. Accounting policies applicable to the acquired assets and
assumed liabilities of the acquiree should be conformed to those of the acquirer after a
business combination in the consolidated financial statements. Dissimilar operations,
assets, or transactions may be a basis for different accounting policies.
27.031b We expect that in most scenarios the accounting policies would be the same in
the consolidated financial statements of the acquirer and the stand-alone financial
statements of the acquiree. However, as the application of pushdown accounting
represents a termination of one basis of accounting and creation of a new basis, in our
view, the acquiree could use a different accounting policy in its stand-alone financial
statements on an on-going basis. In such scenarios, the subsidiary’s policies would need
to be conformed to those of the parent in the consolidated financial statements.
PRESENTATION OF CONTINGENT EXPENSES OF THE ACQUIREE
27.032 Acquirees often incur expenses related to the business combination. Certain
expenses are contingent solely on the consummation of the business combination (e.g.,
investment banking fees paid by the acquiree or share-based awards that accelerate
vesting if the issuer has a change-in-control event). When pushdown accounting is
applied to acquiree financial statements, we believe that preparers have a policy election
to present such expenses in either the predecessor period or on-the-line, as discussed
below. These expenses should not be recognized in the successor period.
• Predecessor presentation - The expense is recognized in the predecessor
period. There is no longer a risk that the consummation of the business
combination will not occur and, therefore, any cost should be recognized at
the closing of the predecessor period.
• On-the-line presentation - On-the-line refers to the vertical line that separates
the predecessor period from the successor period and means that neither the
predecessor nor the successor financial statements include the contingent fees
as expenses. This presentation is analogous to the guidance in ASC
paragraphs 805-20-55-50 and 55-51 that certain costs triggered by the
consummation of the business combination should not be recognized until
consummation occurs, and would not be recognized in the period preceding
the business combination.
27.033 Whichever method is used should be applied consistently to all costs triggered
solely by the consummation of a business combination. Additionally, preparers should
disclose their policy, the facts and circumstances and amounts.
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27. Application of Pushdown Accounting
27.034 The SEC staff addressed the presentation of expenses incurred by the acquiree
that are contingent on the closing of a business combination when pushdown accounting
is applied.1 The staff stated that registrants should determine whether each expense is
most appropriately reflected in the predecessor period, successor period, or on-the-line,
and disclose the amounts recorded in each period and the basis for determining the
amounts included in each category.
27.034a We believe that the staff's reference to contingent expenses being recorded in the
successor income statement refers to situations where the change-in-control event is not
the sole event triggering the expense, such as double trigger awards as discussed in
Example 11.12.
ACQUISITION-RELATED DEBT
27.035 Acquisition-related liabilities incurred by the acquirer are recognized by the
acquiree in its separate financial statements if it is required to do so under U.S. GAAP.
Acquisition-related liabilities include debt, which may be incurred by the acquirer to
finance the acquisition of the acquiree or to finance the acquiree’s operations. The SEC
staff previously provided guidance about when the acquiring entity’s debt, interest
expense, and debt issuance costs should be pushed down to the acquiree in accordance
with SAB Topic 5.J. However, that guidance was rescinded by SAB 115. Pushdown
accounting, including pushdown of debt under SAB Topic 5.J, applied before the
effective date of the new standard and SAB 115, is irrevocable.
Example 27.6: Joint and Several Obligation
ABC Corp. forms and contributes $100 to New Co. on April 1, 20X5. New Co.
acquires a controlling financial interest in DEF Corp. on May 31, 20X5, for $200.
New Co. borrows $100 from a bank to complete this acquisition. Because New Co.
was formed to acquire DEF and has minimal operations, the bank requires that DEF
be jointly and severally liable for repaying the loan.
Whether or not pushdown accounting is elected, generally DEF should record the debt
and interest expense in its separate financial statements based on the guidance in ASC
Subtopic 405-40 after considering whether each of the co-obligors are able to repay
the debt. When DEF records the debt the offsetting entry is to additional paid-in
capital.
27.036 When the acquirer incurs acquisition-related debt that is not pushed down to the
acquiree, the acquiree would record additional paid-in capital in its separate financial
statements.
27.037 Debt and other liabilities may be required to be reflected in the acquiree’s
separate financial statements as a result of applying other U.S. GAAP even if the acquiree
does not apply pushdown accounting. For example, to finance the acquisition, if the
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562
27. Application of Pushdown Accounting
acquirer incurred debt with the acquiree being named as the legal obligor, that debt would
need to be presented in the acquiree’s financial statements even if the acquiree does not
apply pushdown accounting. When debt is recognized in the acquiree's financial
statements, we believe the debt issuance costs and related interest expense would also be
recognized.
27.038 The SEC’s criteria for when debt should be pushed down was rescinded by SAB
115 (see ASU 2015-08). If an acquired entity’s assets or equity are pledged as collateral
against the acquirer’s debt, the acquiree is no longer required nor permitted to reflect that
debt in its separate financial statements unless it is otherwise required to do so under U.S.
GAAP. However, disclosures of such arrangements may be appropriate under other
requirements.
ACQUISITION-RELATED GOODWILL
27.039 If pushdown accounting is applied, all goodwill related to the acquisition is
pushed down to the acquiree and presented as goodwill in the acquiree’s separate
financial statements, even if some of the goodwill is allocated to the other reporting units
in the acquirer’s consolidated financial statements (see KPMG Handbook, Impairment of
nonfinancial assets). If the acquiree is a public business entity, the goodwill is subject to
an annual impairment test under ASC Subtopic 350-20 (see KPMG Handbook,
Impairment of nonfinancial assets). Private company and not-for-profit acquirees may
elect an alternative to amortize goodwill on a straight-line basis over 10 years or less if
another useful life is more appropriate (see Paragraph 26.004). If the alternative is
elected, the private company or not-for-profit entity also makes an accounting policy
election to test goodwill at either the entity level or the reporting unit level and test for
impairment only when a triggering event occurs.
Example 27.7: Goodwill Allocation
ABC Corp. acquires an 80% controlling financial interest in DEF Corp. on January 1,
20X4, for $200 and DEF elects to apply pushdown accounting. ABC recognizes
goodwill of $40 as a result of applying ASC Topic 805. Under ASC Topic 350, ABC
allocates goodwill to its reporting units (RU) as follows:
RU 1 - $5 (expects to benefit from the synergies of the combination);
RU 2 - $10 (expects to benefit from the synergies of the combination); and
RU 3 - $25 (includes all operations of DEF).
Notwithstanding this allocation by ABC to its reporting units, DEF will recognize
goodwill of $40 in its separate financial statements.
When DEF performs its goodwill impairment test, it must follow ASC Topic 350
guidance to assign goodwill to its reporting units and test the $40 for impairment. An
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563
27. Application of Pushdown Accounting
impairment loss from DEF as a result of impairment testing for its reporting units may
not necessarily be recognized in the consolidated financial statements of ABC unless
impairment testing performed at each of ABC's reporting units results in a similar
impairment loss.
27.040 While an impairment loss recognized in a subsidiary’s separate financial
statements may not necessarily be recognized in the parent’s consolidated financial
statements, it may represent a triggering event for the parent company.
27.041 The guidance in ASC Topic 350 requires that the parent assign all goodwill
acquired in a business combination to one or more reporting units on the date of
acquisition. Acquisition-related goodwill should be assigned to the reporting units of the
acquirer that are expected to benefit from the synergies of the combination.
27.042 The ways in which goodwill is allocated to the acquired entity and the parent’s
other reporting units may create differences between the amount of goodwill pushed
down to the acquiree’s separate financial statements (i.e., all of the goodwill from the
transaction) and the goodwill allocated to the acquiree at the parent level. Effectively,
some of the acquiree’s goodwill might be allocated to other reporting units in the
acquirer’s consolidated financial statements.
27.043 If a private company or not-for-profit entity that has been acquired by a public
business entity elects the alternative accounting available for goodwill, the acquiree’s
subsequent accounting for goodwill will be different from the acquirer. Because the
alternative may only be elected by a private company or not-for-profit entity, the effect of
this election would need to be reversed in the parent’s consolidated financial statements.
ACQUIREE WITH FOREIGN ENTITIES
27.044 We believe an acquiree with foreign entities applying pushdown accounting in its
stand-alone financial statements must follow the same guidance on foreign currency
translation of goodwill and other acquisition accounting adjustments that applies to the
acquirer. See Question 5.4.120 in KPMG Handbook, Impairment of nonfinancial assets,
for further discussion.
ACQUISITION COSTS
27.045 The acquirer may incur acquisition costs in a business combination. These costs
include:
• Finder’s fees;
• Advisory, legal, accounting, valuation, and other professional or consulting
fees;
• General administrative costs, including the cost of maintaining an internal
acquisition department; and
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564
27. Application of Pushdown Accounting
• Registering and issuing debt and equity securities.
27.046 Acquisition-related costs incurred by the acquirer should be recorded as expenses
by the acquirer in the periods in which the costs are incurred and the services are
received, with the exception of the costs to issue debt or equity securities that are
recognized under other guidance. Because acquisition costs are expensed by the acquirer
when incurred and are not part of the new basis of the acquiree, they are not to be pushed
down to the acquiree.
27.047 An acquirer may incur acquisition costs in a business combination and require the
acquiree to reimburse them. Because the acquirer’s acquisition costs are not an expense
of the acquiree, the acquiree should record the reimbursement as a distribution to the
acquirer (i.e., not as an expense).
CONTINGENT CONSIDERATION
27.048 Consideration transferred in a business combination may include contingent
consideration. Contingent consideration could arise from an obligation by the acquirer to
transfer additional cash, other assets or equity interests to the former owners of an
acquiree as part of the exchange for control if specified future events occur or conditions
are met. It may also include an acquirer's right to the return of previously transferred
consideration if specified conditions are met. Under ASC Topic 805, the acquirer
recognizes the acquisition-date fair value of the contingent consideration issued by the
acquirer.
27.049 ASC Subtopic 805-50 does not provide guidance about whether the contingent
consideration should be pushed down to the acquiree. We believe that a contingent
consideration asset or liability should be pushed down to the acquiree only if the acquiree
is legally obligated to pay or has the right to receive the contingent consideration. The
contingent consideration would not be pushed down to the acquiree if it represents a legal
right or obligation of the acquirer, not the acquiree. If that occurs and pushdown
accounting is applied, the offset for the obligation that is not pushed down will be an
increase to additional paid-in capital. If the contingent consideration is not a legal
obligation of the acquiree, the acquiree would not report the fair value changes of the
obligation in its separate financial statements.
27.050 The treatment of contingent consideration being pushed down to an acquired
entity would be similar to the treatment of an acquirer's acquisition-related debt that is
pushed down to an acquired entity’s separate financial statements.
ELECTING FAIR VALUE OPTION
27.051 ASC Section 825-10-25 specifies that entities may elect to measure financial
assets and liabilities at fair value, referred to as the fair value option (FVO) for financial
instruments, and also specifies when the FVO may be elected.
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565
27. Application of Pushdown Accounting
ASC Paragraph 825-10-25-4 (Before adoption of ASU 2016-13)2
An entity may choose to elect the fair value option for an eligible item only on
the date that one of the following occurs:
a. The entity first recognizes the eligible item.
b. The entity enters into an eligible firm commitment.
c. Financial assets that have been reported at fair value with unrealized
gains and losses included in earnings because of specialized accounting
principles cease to qualify for that specialized accounting (for example, a
transfer of assets from a subsidiary subject to [ASC] Subtopic 946-10 to
another entity within the consolidated reporting entity not subject to that
Subtopic).
d. The accounting treatment for an investment in another entity changes
because the investment becomes subject to the equity method of
accounting.
1. Subparagraph superseded by Accounting Standards Update No.
2016-01.
2. Subparagraph superseded by Accounting Standards Update No.
2016-01.
e. An event that requires an eligible item to be measured at fair value at
the time of the event but does not require fair value measurement at each
reporting date after that, excluding the recognition of impairment under
lower-of-cost-or-market accounting or other-than-temporary-impairment
or accounting for securities in accordance with Topic 321.
ASC Paragraph 825-10-25-4 (After adoption of ASU 2016-13)
An entity may choose to elect the fair value option for an eligible item only on
the date that one of the following occurs:
a. The entity first recognizes the eligible item.
b. The entity enters into an eligible firm commitment.
c. Financial assets that have been reported at fair value with unrealized
gains and losses included in earnings because of specialized accounting
principles cease to qualify for that specialized accounting (for example, a
transfer of assets from a subsidiary subject to [ASC] Subtopic 946-10 to
another entity within the consolidated reporting entity not subject to that
Subtopic).
d. The accounting treatment for an investment in another entity changes
because the investment becomes subject to the equity method of
accounting.
1. Subparagraph superseded by Accounting Standards Update No.
2016-01.
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27. Application of Pushdown Accounting
2. Subparagraph superseded by Accounting Standards Update No.
2016-01.
e. An event that requires an eligible item to be measured at fair value at
the time of the event but does not require fair value measurement at each
reporting date after that, excluding the recognition of impairment under
lower-of-cost-or-market accounting or accounting for securities in
accordance with either Topic 321 on investments-equity securities or
Topic 326 on measurement of credit losses.
ASC Paragraph 825-10-25-5
Some of the events that require remeasurement of eligible items at fair value,
initial recognition of eligible items, or both, and thereby create an election
date for the fair value option as discussed in [ASC] paragraph 825-10-25-4(e)
are:
a. Business combinations, as defined in [ASC] Subtopic 805-10
b. Consolidation or deconsolidation of a subsidiary or VIE
c. Significant modifications of debt, as defined in [ASC] Subtopic 470-50.
27.052 An entity's election to apply pushdown accounting on a change-in-control event
results in the entity's applying new basis in its accounting, using the principles in ASC
Topic 805. As a consequence, an entity that elects pushdown accounting also may, at that
same date, elect the FVO for any of its eligible financial instruments as prescribed in the
Fair Value Option portion of ASC Section 825-10-25.
APPLICATION OF PUSHDOWN ACCOUNTING AT A LATER
DATE
27.053 If the acquiree does not elect to apply pushdown accounting on a change-in-
control event, it can elect to apply pushdown accounting in a subsequent reporting period
subject to the requirements for a change in accounting principle. In accordance with ASC
paragraph 250-10-45-2, an entity may change an accounting principle only if it justifies
that the alternative accounting principle is preferable. The change in accounting principle
would be applied retrospectively to the date pushdown accounting could have been
elected (i.e., the change-in-control event date).
27.054 Although a change to elect pushdown accounting at a later date is subject to the
change-in-accounting principles requirements, including a conclusion that the new
accounting principle (to apply pushdown accounting) is preferable, an initial decision to
apply pushdown accounting in the period of the change-in-control event is not subject to
a preferability analysis. Once an entity elects to apply pushdown accounting to a specific
change-in-control-event, that decision is irrevocable.
27.055 If pushdown accounting is applied at a later date, the acquiree would
retrospectively adjust its financial statements to reflect the acquirer’s basis at the date
control was obtained and roll forward for subsequent activity between the date control
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27. Application of Pushdown Accounting
was obtained and the date pushdown accounting was elected. Retained earnings would be
reset to zero at the acquisition date and reflect subsequent earnings or losses based on the
new basis established in the pushdown from the acquisition date forward to when the
election to apply pushdown accounting was made.
Example 27.8: Change in Accounting Principle
ABC Corp. acquires a 90% controlling financial interest in DEF Corp. (subsidiary) on
March 31, 20X5, and DEF does not elect to apply pushdown accounting in its separate
financial statements. On December 31, 20X6, DEF elects to apply pushdown
accounting. This election would be treated as a change in accounting principle
(assuming pushdown accounting is deemed to be preferable). Under ASC Topic 250,
DEF would apply the change retrospectively and revise its prior financial statements to
reflect the application of pushdown accounting at the date it could have elected to
apply it (March 31, 20X5, the date of the change-in-control event). The net assets to be
pushed down are the parent’s basis at March 31, 20X5, rolled forward for subsequent
activity from March 31, 20X5, through December 31, 20X6.
Example 27.9: Rolling Forward Subsequent Activity
GHI Corp. acquires all the outstanding common stock of JKL Corp. for $1,000 on
January 1, 20X5. GHI accounts for the acquisition as a business combination under
ASC Topic 805. As of the date of the acquisition, the book value and fair value of
JKL's identifiable net assets are $650 and $800, respectively. GHI records goodwill of
$200 ($1,000 purchase price - $800 fair value of identifiable net assets).
JKL does not elect to apply pushdown accounting in its separate financial statements
on the change-in-control event but elects to apply (and justifies as preferable)
pushdown accounting on January 1, 20X6. Upon the election to apply pushdown
accounting, the amount of net assets (including goodwill) to be pushed down ($800 +
200) is rolled forward for subsequent activity from January 1, 20X5 through January 1,
20X6.
Assume from January 1, 20X5 through January 1, 20X6, JKL has depreciation on an
existing building of $40, acquires additional inventory of $200, collects $50 of
receivables, and incurs debt of $80. The $40 of depreciation includes the additional
depreciation based on the fair value of the assets at the acquisition date. Goodwill is
tested annually for impairment rather than amortized; no impairment loss was
recognized during the period. Upon the election to apply pushdown, JKL would record
the following net assets. The corresponding adjustment would be reflected in JKL's
equity.
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27. Application of Pushdown Accounting
Net assets to be
pushed down at
acquisition date
(January 1, 20X5)
Election to apply
pushdown
accounting
(January 1, 20X6)
Subsequent
Activity
Property, plant, and
equipment
Inventory
Receivables
Goodwill
Liabilities
400
300
300
200
(200)
Total net assets
$ 1,000
(40)
200
(50)
0
(80)
30
360
500
250
200
(280)
1,030
27.056 A U.S. registrant that adopts a change in accounting principle is required to file
with the SEC a letter from its independent accountant indicating its view that the
alternative principle is preferable. Those letters, called preferability letters, should
describe why the accounting principle adopted is preferable to the prior accounting
principle applied.
27.057 For U.S. SEC registrants, preferability letters must be included as Exhibit 18 in
the first applicable filing under the Securities Exchange Act of 1934 (i.e., Form 10-Q or
Form 10-K) following the accounting change. The letter need only be filed once. A
preferability letter is required in Form 10-K only when the change in accounting principle
occurred in the fourth quarter.
FORGOING THE ELECTION TO APPLY PUSHDOWN
ACCOUNTING
27.058 An entity that has been acquired by a new controlling parent may decide not to
apply pushdown accounting. This decision could be made for a number of reasons. If
pushdown accounting is not applied by an entity acquired by a new controlling parent,
practical difficulties could arise in subsequent periods due to the burden of managing and
maintaining two sets of accounting records for the acquired entity. These difficulties
could occur, for example, from having to perform two separate impairment analyses,
maintaining two sets of records to track depreciation and amortization balances along
with the corresponding tax balances, and recording different gains and losses when
individual assets are sold. These difficulties could be further compounded if multiple
reporting entities are acquired and they make different elections with respect to
pushdown accounting. Entities should consider these practical difficulties during their
decision-making process.
27.059 The EITF and FASB decided that when an entity elects pushdown accounting,
certain disclosures will be required to enable financial statement users to evaluate the
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27. Application of Pushdown Accounting
nature and effect of pushdown accounting. Furthermore, the EITF and FASB decided that
an entity is not required to assess whether a change-in-control event has occurred at each
reporting date.
MANAGEMENT RESPONSIBILITIES FOR ICOFR
ACQUIRER’S CONSOLIDATED FINANCIAL STATEMENTS
27.060 When the acquirer is an SEC registrant subject to the requirements of Section 404
of the Sarbanes-Oxley Act of 2002, it will need to design, implement, and assess the
operating effectiveness of internal controls over financial reporting (ICOFR) related to
the financial reporting implications the newly acquired entity may have on its
consolidated financial statements. While the SEC permits the acquirer to exclude the
internal controls that operate at the acquired business from management’s report on
ICOFR in the year of acquisition, the acquirer’s management is still required to assess its
own internal controls over the recognition, measurement, and disclosure implications of
the acquisition. In the subsequent year, the acquirer’s management will need to assess the
design and operating effectiveness of the internal controls over the acquiree.
ACQUIREE SEPARATE FINANCIAL STATEMENTS
27.061 If the acquiree is required to assess the effectiveness of ICOFR either because it
or its parent company is subject to the requirements of Section 404 of the Sarbanes-Oxley
Act of 2002, its management will also need to ensure it has controls around the financial
statement recognition, measurement, and disclosure implications resulting from the
application of pushdown accounting. Examples could include internal controls around the
accurate initial and subsequent recording of pushdown accounting journal entries,
ensuring those balances are accurately reflected in the acquired entity’s financial
statements, appropriately recognizing acquisition-related liabilities, and having
appropriate internal controls around new disclosure requirements.
CHANGE IN TAX BASIS
27.062 Deferred income taxes generally should be recognized for temporary differences
related to the assets and liabilities included in both the consolidated and stand-alone
financial statements. The amounts of those temporary differences for the acquired entity’s
assets and liabilities may not be the same in the consolidated and separate financial
statements because business combination accounting adjustments reflected in the
consolidated financial statements may not have been pushed down to the acquired
entity’s separate financial statements.
27.063 When an acquisition is treated as a taxable transaction (resulting in a step-up in
the basis of the assets and liabilities for tax purposes) and the acquired entity does not
apply pushdown accounting in its separate financial statements, the step-up in basis of the
financial statement carrying amount is not reflected in the acquired entity’s financial
statements. In this instance, the change in the temporary difference due to the change in
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27. Application of Pushdown Accounting
tax basis is recognized as an adjustment to equity. Further, a valuation allowance
recorded as of the acquisition date for the newly created deferred tax assets should also
be recognized with an adjustment to equity. However, any subsequent change to the
valuation allowance or change in the valuation allowance for existing deferred tax assets
(including the write-off of existing deferred tax assets that the acquired entity can no
longer realize as a result of the business combination) should be recognized as a
component of income from continuing operations.
SEC AND CALL REPORT CONSIDERATIONS
27.064 The SEC issued SAB 115 (see ASU 2015-08) that rescinded its guidance on
pushdown accounting previously contained in SAB Topic 5.J (ASC paragraph 805-50-
S99-1). This action conforms SEC guidance to the new standard. The SEC staff also
announced at the March 19, 2015 EITF meeting that the previous SEC staff
announcements at EITF meetings (ASC paragraph 805-50-S99-2) and SEC Observer
comments (ASC paragraph 805-50-S99-3) were being withdrawn.
27.065 ASC paragraph 805-50-S99-2, formerly EITF Topic D-97, stated (before being
withdrawn) that the SEC staff believes that pushdown accounting is required if a
company becomes substantially wholly owned by a group of investors who act together
as effectively one investor and are able to control the form of ownership of the investee
and collaborate on its subsequent control (the collaborative group). For example,
pushdown accounting would have been applied when three investors were part of a
collaborative group based on the guidance in ASC paragraph 805-50-S99-2 and the
investors acquired 30%, 30%, and 40%, respectively.
27.066 Because the collaborative group guidance is withdrawn, an entity acquired by a
group of new investors who collaborate (e.g., 30%, 30%, and 40% without a contractual
agreement that gives one party control), would not be able to elect pushdown accounting
because no one investor obtains control of the entity.
27.067 A consolidated group of companies or an individual company frequently consists
of multiple divisions or subsidiaries that would individually qualify as a business as
defined in S-X Article 11. However, the parent company may not maintain or receive
audited financial statements of each business component separately. When a registrant
acquires a portion of a larger business (e.g., division), the audited financial statements of
the acquired portion are required if that acquired business is itself deemed significant to
the registrant. These financial statements often are referred to as carve-out financial
statements.
27.068 The SEC staff updated its Financial Reporting Manual, which provides general
guidance about financial reporting matters, to conform to the issuance of ASU 2014-17
and the rescission of SAB Topic 5.J. The SEC staff made changes to Section 7410 to
remove the requirements to push down the parent’s basis in a separate component’s
financial statements. Therefore, pushdown accounting would be elective for carve-out
financial statements.
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571
27. Application of Pushdown Accounting
27.069 Call Report. The Federal Financial Institution Examination Council (federal
banking agencies) issued Supplemental Instructions for December 2014 Call Reports that
address pushdown accounting. The federal banking agencies rescinded the existing
requirement for pushdown accounting that was consistent with SAB Topic 5.J and
adopted ASU 2014-17 for Call Report purposes. However, consistent with prior Call
Reports, an entity’s primary federal regulator may require or prohibit the use of
pushdown accounting for Call Report purposes based on the regulator’s evaluation of
whether the election appears not to be supported by the facts and circumstances of the
business combination.
1 Carlton Tartar speech at the 2014 AICPA Conference on Current SEC and PCAOB developments,
available at www.sec.gov.
2 ASU 2016-13, Measurement of Credit Losses on Financial Instruments, modifies subparagraph (e) of
ASC paragraph 825-10-25-4.
ASU 2016-13 is effective for public business entities that are SEC filers, excluding entities eligible to be
smaller reporting companies as defined by the SEC, for annual and interim periods in fiscal years beginning
after December 15, 2019. The one-time determination of whether an entity is eligible to be a smaller
reporting company shall be based on an entity’s most recent determination as of November 15, 2019, in
accordance with SEC regulations.
For all other entities, it is effective for annual and interim periods in fiscal years beginning after December
15, 2022. Early adoption is permitted for annual and interim periods in fiscal years beginning after
December 15, 2018.
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572
Section 28 - Combinations of Entities
Under Common Control
Detailed Contents
Change in Reporting Entity
Common Control
Definition of Common Control
Entities Controlled by a Common Ownership Group
Example 28.1: Entities Controlled by Common Ownership
Combinations Between Entities or Businesses with a High Degree of Common
Ownership
Example 28.2: Transfer or Exchange Between Entities with a High Degree of
Common Ownership
Accounting for A Change in Noncontrolling Interests from a Common Control
Transaction
Example 28.2a: Acquisition of Noncontrolling Interest under Common Control
Transfers of Net Assets or Equity Interests between Entities Under Common Control
Accounting and Reporting by the Receiving Entity
Example 28.2b: Accounting by the Receiving Entity in a Combination of Entities
under Common Control
Example 28.2c: Adjustment to Consideration Payable after Common Control
Ends (Asset Acquisition)
Example 28.3: Change in Reporting Entity of Receiving Entity
Presentation of Prior Period Financial Statements
Example 28.4: Prior Period Financial Statements of Receiving Entity
Conforming Accounting Methods
Presentation of Historical Earnings per Share
Distribution of Cash or Assumption of Liabilities
Example 28.5: Accounting for Distribution of Cash or Assumption of Liabilities
Costs Related to Combinations of Entities Under Common Control
Goodwill Impairment
Example 28.6: Two Methods of Goodwill Impairment
Identifying the Predecessor Entity When Entities Are Not Under Common Control for
All Comparative Periods
Example 28.7: Identifying the Predecessor Entity
Accounting and Reporting by the Transferring Entity
Financial Statement Presentation of Contributed Net Assets or Equity Interests
Recognition of Differences Between Amounts Contributed and Proceeds Received
Impairment Considerations
Example 28.8: Trigger for Impairment Evaluation
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573
28. Combinations of Entities under Common Control
28.000 ASC Topic 805 carries forward the previously existing guidance on accounting
for combinations involving entities under common control. ASC Topic 805 specifically
excludes combinations between entities or businesses under common control from the
scope of the business combinations guidance. Common control transactions do not meet
the definition of a business combination because there has not been an acquisition by
parties outside the continuing control group (i.e., no change-in-control event).
Combinations between entities or businesses under common control involve exchanges or
movements of net assets or equity interests between entities controlled, directly or
indirectly, by the same parent, investor, or ownership group that has agreed to vote in
concert.
28.001 ASC Subtopic 805-50 provides guidance about accounting for transactions
between entities under common control. Even though the disclosure requirements apply
specifically to the receiving entity, we believe the transferring entity should consider
making similar disclosures.
Overview
ASC Paragraph 805-50-05-4
As noted in [ASC] paragraph 805-10-15-4(c), the guidance related to business
combinations does not apply to combinations between entities or businesses under
common control.
ASC Paragraph 805-50-05-5
Some transfers of net assets or exchanges of shares between entities under
common control result in a change in the reporting entity. In practice, the method
that many entities have used to account for those transactions is similar to the
pooling-of-interests method. The Transactions between Entities under Common
Control Subsections provide guidance on preparing financial statements and
related disclosures for the entity that receives the net assets.
Scope
ASC Paragraph 805-50-15-5
The guidance in the Transactions between Entities under Common Control
Subsections applies to all entities.
ASC Paragraph 805-50-15-6
The guidance in the Transactions between Entities under Common Control
Subsections applies to combinations between entities or businesses under
common control. The following are examples of those types of transactions:
a. An entity charters a newly formed entity and then transfers some or all of its
net assets to that newly chartered entity.
b. A parent transfers the net assets of a wholly owned subsidiary into the
parent and liquidates the subsidiary. That transaction is a change in legal
organization but not a change in the reporting entity.
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574
28. Combinations of Entities under Common Control
c. A parent transfers its controlling interest in several partially owned
subsidiaries to a new wholly owned subsidiary. That also is a change in legal
organization but not in the reporting entity.
d. A parent exchanges its ownership interests or the net assets of a wholly
owned subsidiary for additional shares issued by the parent's less-than-wholly-
owned subsidiary, thereby increasing the parent's percentage of ownership in
the less-than-wholly-owned subsidiary but leaving all of the existing
noncontrolling interest outstanding.
e. A parent's less-than-wholly-owned subsidiary issues its shares in exchange
for shares of another subsidiary previously owned by the same parent, and the
noncontrolling shareholders are not party to the exchange. That is not a
business combination from the perspective of the parent.
f. A limited liability company is formed by combining entities under common
control.
g. Two or more not-for-profit entities (NFPs) that are effectively controlled by
the same board members transfer their net assets to a new entity, dissolve the
former entities, and appoint the same board members to the newly combined
entity.
ASC Paragraph 805-50-15-6A
The guidance in the Transactions between Entities under Common Control
Subsections does not apply to the initial measurement by a primary beneficiary of
the assets, liabilities, and noncontrolling interests of a VIE if the primary
beneficiary of a VIE and the VIE are under common control. Guidance for such a
VIE is provided in [ASC] Section 810-10-30.
ASC Paragraph 805-50-15-6B
Mergers and acquisitions between or among two or more NFPs, all of which
benefit a particular group of citizens, shall not be considered common control
transactions solely because those entities benefit a particular group. The mission,
operations, and historical sources of support of two or more NFPs may be closely
linked to benefiting a particular group of citizens. However, that group neither
owns nor controls the NFPs.
Recognition
ASC Paragraph 805-50-25-2
When accounting for a transfer of assets or exchange of shares between entities
under common control, the entity that receives the net assets or the equity
interests shall initially recognize the assets and liabilities transferred at the date of
transfer. See the Transactions between Entities under Common Control
Subsection of [ASC] Section 805-50-45 for guidance on the presentation of
financial statements for the period of transfer and comparative financial
statements for prior years.
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28. Combinations of Entities under Common Control
Initial Measurement
ASC Paragraph 805-50-30-5
When accounting for a transfer of assets or exchange of shares between entities
under common control, the entity that receives the net assets or the equity
interests shall initially measure the recognized assets and liabilities transferred at
their carrying amounts in the accounts of the transferring entity at the date of
transfer. If the carrying amounts of the assets and liabilities transferred differ from
the historical cost of the parent of the entities under common control, for example,
because pushdown accounting had not been applied, then the financial statements
of the receiving entity shall reflect the transferred assets and liabilities at the
historical cost of the parent of the entities under common control.
ASC Paragraph 805-50-30-6
In some instances, the entity that receives the net assets or equity interests (the
receiving entity) and the entity that transferred the net assets or equity interests
(the transferring entity) may account for similar assets and liabilities using
different accounting methods. In such circumstances, the carrying amounts of the
assets and liabilities transferred may be adjusted to the basis of accounting used
by the receiving entity if the change would be preferable. Any such change in
accounting method shall be applied retrospectively, and financial statements
presented for prior periods shall be adjusted unless it is impracticable to do so.
[ASC] Section 250-10-45 provides guidance if retrospective application is
impracticable.
Other Presentation Matters
ASC Paragraph 805-50-45-1
[ASC] Paragraph 805-50-25-2 establishes that the assets and liabilities transferred
between entities under common control are to be initially recognized by the
receiving entity at the transfer date. This Subsection provides guidance on the
presentation of financial statements for the period of transfer and comparative
financial statements for prior years.
ASC Paragraph 805-50-45-2
The financial statements of the receiving entity shall report results of operations
for the period in which the transfer occurs as though the transfer of net assets or
exchange of equity interests had occurred at the beginning of the period. Results
of operations for that period will thus comprise those of the previously separate
entities combined from the beginning of the period to the date the transfer is
completed and those of the combined operations from that date to the end of the
period. By eliminating the effects of intra-entity transactions in determining the
results of operations for the period before the combination, those results will be
on substantially the same basis as the results of operations for the period after the
date of combination. The effects of intra-entity transactions on current assets,
current liabilities, revenue, and cost of sales for periods presented and on retained
earnings at the beginning of the periods presented shall be eliminated to the extent
possible.
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576
28. Combinations of Entities under Common Control
ASC Paragraph 805-50-45-3
The nature of and effects on earnings per share (EPS) of nonrecurring intra-entity
transactions involving long-term assets and liabilities need not be eliminated.
However, [ASC] paragraph 805-50-50-2 requires disclosure.
ASC Paragraph 805-50-45-4
Similarly, the receiving entity shall present the statement of financial position and
other financial information as of the beginning of the period as though the assets
and liabilities had been transferred at that date.
ASC Paragraph 805-50-45-5
Financial statements and financial information presented for prior years also shall
be retrospectively adjusted to furnish comparative information. All adjusted
financial statements and financial summaries shall indicate clearly that financial
data of previously separate entities are combined. However, the comparative
information in prior years shall only be adjusted for periods during which the
entities were under common control.
Disclosure
ASC Paragraph 805-50-50-1
[ASC] Paragraphs 805-50-45-1 through 45-5 provide guidance on financial
statement presentation in the period of transfer and for periods before the transfer
of assets and liabilities between entities under common control. This Subsection
addresses incremental disclosures related to such a transaction.
ASC Paragraph 805-50-50-2
The nature of and effects on earnings per share (EPS) of nonrecurring intra-entity
transactions involving long-term assets and liabilities is not required to be
eliminated under the guidance in [ASC] paragraph 805-50-45-3 but shall be
disclosed.
ASC Paragraph 805-50-50-3
The notes to financial statements of the receiving entity shall disclose the
following for the period in which the transfer of assets and liabilities or exchange
of equity interests occurred:
a. The name and brief description of the entity included in the reporting entity
as a result of the net asset transfer or exchange of equity interests.
b. The method of accounting for the transfer of net assets or exchange of
equity interests.
ASC Paragraph 805-50-50-4
The receiving entity also shall consider whether additional disclosures are
required in accordance with [ASC] Section 850-10-50, which provides guidance
on related party transactions and certain common control relationships.
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577
28. Combinations of Entities under Common Control
CHANGE IN REPORTING ENTITY
28.002 The FASB carried forward without reconsideration ASC Subtopic 805-50
guidance for accounting for transfers of net assets or exchanges of equity interests
between entities under common control. ASC paragraph 805-50-05-5 states that some
transfers of net assets or exchanges of shares between entities under common control
result in a change in the reporting entity. ASC Topic 250, Accounting Changes and Error
Corrections, defines a change in the reporting entity as financial statements that, in effect,
are those of a different reporting entity and that the changes generally are limited to (1)
presenting consolidated or combined financial statements in place of financial statements
of individual entities, (2) changing specific subsidiaries that make up the group of entities
for which consolidated financial statements are presented, and (3) changing the entities
included in combined financial statements. If the equity interests or net assets transferred
between entities under common control meet the definition of a business, the transaction
will generally result in a change in reporting entity that is accounted for by recognizing
the net assets received at the carrying amount (or ultimate parent’s historical cost if
pushdown accounting was not applied) and retrospectively revising all comparative
periods presented. This accounting is sometimes referred to as the as-if pooling-of-
interests method.
28.003 If the equity interests or net assets transferred between entities under common
control do not constitute the transfer of a business, including when a nonsubstantive
holding company is added to an existing entity or consolidated group, a change in
reporting entity generally has not occurred. Transfers of assets between entities under
common control that do not result in a change in reporting entity are generally accounted
for prospectively (i.e., comparative periods are not recast).
COMMON CONTROL
DEFINITION OF COMMON CONTROL
28.004 Only transactions in which all combining entities in the transaction are controlled
by the common parent or a controlling ownership group that has agreed to vote in concert
both before and after the combination qualify as combinations of entities under common
control. As a general rule, ownership by one entity, directly or indirectly, of over 50% of
the outstanding voting shares of another entity represents control. Control could also be
achieved by means other than majority ownership of outstanding voting shares (i.e.,
contractual, agreement, or irrevocable assignment of ownership rights). Two or more
entities may be deemed to be under common control when they are subject to control by
the same parent, investor, or ownership group that has agreed to vote in concert. As used
here, control has the same meaning as used in the FASB’s guidance on consolidation
(ASC 810-10). See Section 2 of this book for a discussion on the definition of control.
28.005 The term common control is not defined in ASC Topic 805. EITF Issue No. 02-5,
“Definition of ‘Common Control’ in Relation to FASB Statement No. 141,” discusses
whether separate entities are under common control when there is common majority
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578
28. Combinations of Entities under Common Control
ownership by an individual, a family, or a group affiliated in some other manner. The
EITF did not reach a consensus. However, during the discussion, the SEC Observer
stated that the SEC staff believes common control exists in the following situations:
a. An individual or enterprise holds more than 50% of the voting ownership
interest of each entity.
b. Immediate family members hold more than 50% of the voting ownership
interest of each entity and there is no evidence that those family members will
not vote their shares in concert. Immediate family members include a married
couple and their children, but not the married couple’s grandchildren.
Situations in which entities are owned in varying combinations among living
siblings and their children require careful consideration regarding the
substance of the ownership and voting relationships in determining whether
the related entities are under common control.
c. A group of shareholders holds more than 50% of the voting ownership of each
entity, and that group provides contemporaneous written evidence of an
agreement to vote a majority of the entities’ shares in concert.
28.006 While this SEC Observer comment was not carried forward into the Codification,
our experience is that this observer comment generally holds in practice. Judgment is
required to determine whether common control exists in situations other than those
described above.
28.007 See KPMG Handbook, Consolidation of Variable Interest Entities, for discussion
of means of control other than voting ownership interests, such as ownership of another
variable interest, as consideration should be given to all of the facts and circumstances
surrounding the relationships between the parties.
ENTITIES CONTROLLED BY A COMMON OWNERSHIP GROUP
28.008 Under ASC paragraph 805-50-30-5, the receiving entity should measure the net
assets received in a combination of entities that are under common control at the
historical cost of the ultimate parent.
Example 28.1: Entities Controlled by Common Ownership
Five owners are subject to an owners’ agreement that includes the necessary
provisions to treat the five owners as a controlling ownership group. The five owners
hold the following percentages of voting common stock in four combining enterprises.
Owner
Co W
Co X
Co Y
Co Z
A
B
0
15
5
0
65
15
0
60
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579
28. Combinations of Entities under Common Control
C
D
E
Unaffiliated
owners
15
15
0
55
35
30
10
20
0
10
10
0
15
10
0
15
Owners A, B, C, D, and E have agreed to a business combination in which those
owners will exchange their interests in Co W, Co X, Co Y, and Co Z for interests in
NEWCO. Co W, Co X, Co Y, and Co Z each constitute a business. The business
combination should be treated as a combination of entities under common control.
NEWCO’s consolidated financial statements for periods before the business
combination would include the historical cost basis of Co X’s, Co Y’s, and Co Z’s
assets and liabilities for all prior periods in which the controlling ownership group
held a controlling financial interest in the combining entities. The interests held by the
unaffiliated owners in Co X and Co Z would be presented as noncontrolling interests
in NEWCO's consolidated financial statements for all periods presented (see Chapter
7 of KPMG Handbook, Consolidation if the unaffiliated owners’ interests in Co X and
Co Z are acquired by NEWCO).
NEWCO’s consolidated financial statements for all periods presented would reflect
the historical cost basis of Co W on the equity method because the controlling
ownership group did not hold a controlling financial interest in Co W during those
periods.
COMBINATIONS BETWEEN ENTITIES OR BUSINESSES WITH A
HIGH DEGREE OF COMMON OWNERSHIP
28.009 A transaction between entities with a high degree of common ownership, but that
are not under common control, should be assessed to determine whether the transaction
lacks substance. Paragraph 6 of FASB Technical Bulletin No. 85-5, Issues Relating to
Accounting for Business Combinations, stated, “if the exchange lacks substance, it is not
a purchase event and should be accounted for based on existing carrying amounts.”
Although FASB Technical Bulletin No. 85-5 was superseded by Statement 141(R), we
believe this guidance remains relevant for transactions that lack economic substance.
28.010 The SEC staff has indicated that in a transfer or exchange between entities with a
high degree of common ownership, they often compare the percentage owned by
shareholders in the combined entity to the percentages owned in each of the combining
entities before the transaction. When the percentages have changed (even by small
amounts) or the owned interests are not in substance the same before and after the
transaction, the SEC staff believes a substantive transaction has occurred and historical
cost accounting is not appropriate.
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580
28. Combinations of Entities under Common Control
Example 28.2: Transfer or Exchange Between Entities with a High
Degree of Common Ownership
Assume that Investor A and Investor B each own 50% of Company X and Company
Y. Investor A and Investor B are unrelated and they have no agreement that would
cause them collectively to be a controlling group over their investees. Company X
acquires Company Y by exchanging new shares of Company X for all of the
outstanding shares of Company Y previously held by Investor A and Investor B. After
the transaction, each investor continues to own 50% of Company X and Company X
owns 100% of Company Y.
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581
28. Combinations of Entities under Common Control
Structure after the transaction
Ownership Interests
Investor A
Investor B
Company XY
50%
50%
100%
Investor A
Investor B
50%
50%
Company X
100%
Company Y
Should Company X account for the acquisition of Company Y as a business
combination?
The percentage that each investor owns in the combined company is the same
percentage they each owned before the transaction. Therefore, we believe the transfer
of ownership is a non-substantive exchange and should be accounted for by Company
X at carry over basis on an as-if pooling-of-interests basis. We note, however, that
even small changes in the ownership percentages or other economic factors could
result in the conclusion that a transaction has substance and should be accounted for
as a business combination under ASC Topic 805.
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582
28. Combinations of Entities under Common Control
ACCOUNTING FOR A CHANGE IN NONCONTROLLING
INTERESTS FROM A COMMON CONTROL TRANSACTION
28.011 Under ASC paragraphs 810-10-45-21A through 45-24, the accounting and
reporting requirements for changes in noncontrolling interests in a subsidiary require that
an increase in a parent’s (including a common control group) ownership interest in a
subsidiary is accounted for as an equity transaction. Additionally, a decrease in
ownership of a subsidiary while maintaining control also is accounted for as an equity
transaction unless a scope exception is provided.1 Therefore, for these transactions, no
gain or loss is recognized in income in the parent’s financial statements. This also means
that there is no change in the carrying amount of the subsidiary’s assets or liabilities. This
accounting treatment is consistent with the view that noncontrolling interest holders are a
part of the ownership interest in the consolidated entity. Therefore, transactions involving
the interests held by those noncontrolling owners should be reflected as equity
transactions in the consolidated financial statements.
28.012 If the parent retains a controlling financial interest in a subsidiary, the transaction
will be recorded as an equity transaction. Accordingly, the carrying amount of the
noncontrolling interest is adjusted to reflect the change in ownership in a subsidiary as a
result of the transaction.
Example 28.2a: Acquisition of Noncontrolling Interest under Common
Control
Parent owns a controlling 100% interest in Subsidiary X and a controlling 75%
interest in Subsidiary Y. ABC an unrelated third party owns the other 25% of
Subsidiary Y. Both X and Y meet the definition of a business. The fair values and
carrying amounts are as follows.
Subsidiary X
Subsidiary Y
Total
Carrying
amount of
net assets
Carrying
amount
of NCI
Fair value
$ 125
500
$ 625
$ 80
200
$ 280
$ 0
50
$ 0
Parent and ABC enter into a reorganization executed in the following steps.
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583
28. Combinations of Entities under Common Control
Before the transaction:
Step 1: Parent transfers its controlling interest in Subsidiary Y to Subsidiary X. The
transfer of Subsidiary Y to X is a common control transaction.
Step 2: In conjunction with the transaction, the NCI holder of Subsidiary Y exchanges
its 25% interest in Subsidiary Y for a 20% NCI in Subsidiary X.
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584
28. Combinations of Entities under Common Control
Parent's financial statements
Parent accounts for each step of the transaction as follows:
Step 1: The common control transaction does not affect the carrying amount of assets
and liabilities in Parent's consolidated financial statements.
Step 2: The issuance of the 20% NCI in Subsidiary X in exchange for the outstanding
25% NCI in Subsidiary Y is accounted for as an equity transaction. Parent records the
following journal entry:
NCI – Subsidiary Y
Equity/APIC
50
6
NCI – Subsidiary X
56 (20% of 280)
Subsidiary X financial statements
Subsidiary X accounts for each step in its separate financial statements as follows:
Step 1: Subsidiary X recasts its historical financial statements to include Subsidiary Y
because Y is a business and a change in reporting entity occurred. In the recast
financial statements, a 25% NCI in Subsidiary Y is reflected in the periods prior to the
transaction and 25% of the income or loss of Y is attributed to the NCI holder.
Step 2: At the date of the transfer and exchange of the interest in Subsidiary Y for the
20% interest in Subsidiary X, Subsidiary X eliminates the NCI in its financial
statements with an offsetting entry to APIC and no further income or loss is attributed
to an NCI holder.
28.013 If a parent ceases to have a controlling financial interest in a subsidiary, then the
parent is required to deconsolidate the subsidiary as of the date it loses control over that
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28. Combinations of Entities under Common Control
subsidiary. For more information on accounting for noncontrolling interests in
consolidated financial statements, see Section 7 of this book. However, if a parent
deconsolidates a subsidiary through a nonreciprocal transfer to owners, such as a spinoff,
the accounting guidance in ASC Topic 845 applies.
TRANSFERS OF NET ASSETS OR EQUITY INTERESTS
BETWEEN ENTITIES UNDER COMMON CONTROL
ACCOUNTING AND REPORTING BY THE RECEIVING ENTITY
28.014 Under ASC paragraph 805-50-30-5, assets and liabilities transferred or shares
exchanged between entities under common control are accounted for at the historical cost
of those entities’ ultimate parent, in a manner similar to which a pooling-of-interests was
accounted for under APB 16, Business Combinations (as-if pooling-of-interests
accounting). If the carrying amount of the assets and liabilities transferred differs from
the historical cost of the parent of the entities under common control, for example,
because push-down accounting had not been applied, then the financial statements of the
receiving entity should reflect the transferred assets and liabilities at the historical cost of
the parent of the entities under common control.
Example 28.2b: Accounting by the Receiving Entity in a Combination of
Entities under Common Control
An investment fund (the Fund) has two portfolio companies (Company A and
Company B) that the Fund is planning to combine as entities under common control
by contributing the stock of Company A to Company B in preparation for an IPO.
Company A was acquired by the Fund a number of years ago and pushdown
accounting has never been applied to the separate financial statements of Company A.
As an investment company, the Fund never completed acquisition accounting in its
financial statements because the investment in Company A was accounted for at fair
value after acquisition.
The consolidated financial statements of Company B will reflect the Fund’s basis in
Company A because ASC paragraph 805-50-30-5 requires that the financial
statements of the receiving entity reflect the transferred assets and liabilities at the
historical cost of the parent as though acquisition accounting had been applied from
the date the Fund acquired Company A, with amounts adjusted for subsequent
depreciation, amortization, accretion, impairment, etc. (essentially forcing pushdown
accounting to be applied).
28.015 Any difference in the amount paid (or payable) by the transferee versus the
historical cost of the assets (i.e., parent basis) transferred to the transferee is recorded as
an adjustment to equity by the transferee/subsidiary and investment by the parent (i.e., as
a capital contribution or distribution). A subsequent adjustment to the amount paid (or
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28. Combinations of Entities under Common Control
payable) to the transferor is also recorded in equity. We believe the subsequent
adjustment should be recorded in equity even if common control no longer exists at the
time of the subsequent adjustment to the amount paid (or payable), unless the reporting
entity has adopted a new basis of accounting (e.g., as a result of applying pushdown
accounting following a subsequent acquisition). See ASC Subtopic 845-10, Nonmonetary
Transactions - Overall for a discussion of exchanges, transfers, and other nonmonetary
transactions.
28.015a As an exception, it is generally acceptable for routine transfers of inventory for
which valuation is not in question between entities under common control in the ordinary
course of business to be accounted for as sales (including gain recognition by the
transferor and a step-up in basis for the transferee).
Example 28.2c: Adjustment to Consideration Payable after Common
Control Ends (Asset Acquisition)
On June 30, 20X8, Subsidiary acquires from Parent a newly constructed power plant
that is pending regulatory inspection in a common control transaction. Subsidiary
records the asset at Parent’s carrying amount ($30). Total consideration is $50,
consisting of $45 of cash at the acquisition date and a $5 payment contingent on
regulatory certification of the plant (expected to occur in October 20X8). The
contingent payment is akin to a holdback and is considered highly certain to occur,
and Subsidiary recognizes a liability of $5 at the date of transfer. As described in
Paragraph 28.015, the difference between Parent’s carrying amount of the asset and
the amount paid (or payable) is recorded as an adjustment ($20 reduction) to equity.
On August 30, 20X8, Parent sells the stock of Subsidiary to an unrelated acquirer and
common control ends. Subsidiary elects not to apply pushdown accounting in its
stand-alone financial statements. At that time, the $5 consideration is still payable as
certification has not yet occurred. In October 20X8, the regulator identifies
deficiencies in the plant that Subsidiary must remediate before certification. As a
result, Subsidiary negotiates with (its former) Parent to settle the outstanding payment
at $3.
We believe Subsidiary should record the $2 adjustment to the liability in equity in its
stand-alone financial statements, consistent with how it would have recorded the
adjustment if common control still existed. That is, the net result is the same as if the
consideration had been fixed at $48 at the time of the common control transaction.
If Subsidiary had elected to apply pushdown accounting, that would have created a
new basis of accounting for both the asset and the liability, and Subsidiary would
record the adjustment to the liability in its income statement.
If Parent and Subsidiary had not been under common control at the time of the
transfer, the guidance on asset acquisitions would have applied. Subsidiary would
have recorded the asset initially at its cost ($50, plus any acquisition-related costs),
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28. Combinations of Entities under Common Control
and the $2 adjustment would have reduced the carrying amount of the asset (see
KPMG Issues In-Depth, Asset acquisitions, Section 3.5 and Section 4.8).
28.015b If a transaction is a transfer of financial assets within the scope of ASC Topic
860, Transfers and Servicing, it should be evaluated and accounted for under that
guidance. Evaluating whether a transfer of financial assets between entities under
common control is recognized as a sale under ASC Topic 860 requires careful
consideration of the relationship between the involved parties. See paragraph 860-10-55-
78 for additional application guidance for transfers of financial assets between
subsidiaries of a common parent and paragraph 860-10-55-17D for guidance on transfers
from a parent to a consolidated subsidiary.
28.016 If a transaction results in the acquisition of all, or part, of a noncontrolling equity
interest in a subsidiary, the acquisition of the noncontrolling interest is accounted for as
an equity transaction under ASC Topic 810, Consolidation. Likewise, if a common
control transaction results in an increase in the noncontrolling interest of a subsidiary
(i.e., disposition of a portion of the parent's interest in a subsidiary while the parent
retains control after the transaction), the transaction is also accounted for as an equity
transaction under ASC Topic 810. No gain or loss is recognized in consolidated net
income or comprehensive income as a result of changes in noncontrolling interests when
the ultimate parent retains control of the subsidiary.
Example 28.3: Change in Reporting Entity of Receiving Entity
Parent Company owns 100% of the voting stock of Subsidiary B and 100% of the
voting stock of Subsidiary C. Subsidiary B and Subsidiary C own 45% and 40% of the
voting stock of Subsidiary D, respectively. An unrelated entity owns the remaining
15% of Subsidiary D’s voting stock.
Subsidiary C transfers its 40% ownership of Subsidiary D to Subsidiary B.
The Parent Company's noncontrolling interest in Subsidiary D is $150. Its carrying
value of controlling financial interest in Subsidiary D is $850 (representing 85% of
Subsidiary D’s equity).
The transfer of Subsidiary C's equity interest in Subsidiary D to Subsidiary B is a
common control transaction and is recorded by Subsidiary B at the parent’s carrying
amount of $400 ($850 × (40% / 85%). This transaction does not affect the
consolidated financial statements of Parent Company because its total ownership
interest in Subsidiary D has not changed. However, if Subsidiary B presents stand-
alone consolidated financial statements, the transfer of Subsidiary C's 40% interest in
Subsidiary D would result in a change in reporting entity for Subsidiary B.
Consequently, Subsidiary B will include Subsidiary D in its financial statements using
the as-if pooling-of-interests method described in ASC Subtopic 805-50 and,
accordingly, Subsidiary B would retrospectively consolidate Subsidiary D and include
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28. Combinations of Entities under Common Control
Subsidiary D’s results of operations in its consolidated results of operations for all
periods presented (assuming that Subsidiary D is a business and was under common
control for all historical periods).
PRESENTATION OF PRIOR PERIOD FINANCIAL STATEMENTS
28.017 In as-if pooling-of-interests accounting, financial statements of the previously
separate companies for periods before the combination are recast on a combined basis for
all prior periods that the entities are under common control, assuming a change in
reporting entity has occurred. ASC paragraph 805-50-45-5 specifies that the financial
statements of previously separate entities are not combined for periods before the date
that common control was established. When applying the guidance for a change in
reporting entity, the financial statements should be presented for all periods as if the
combination occurred at the inception of common control or as of the earliest period
presented if the entities are under common control for all periods presented, unless it is
impracticable to do so (see ASC paragraph 250-10-45-9).
Example 28.4: Prior Period Financial Statements of Receiving Entity
Company A has a controlling financial interest in Company B. On January 1, 20X2,
Company A acquires a controlling financial interest in Company C. Company A
merges Company C into Company B on January 1, 20X3 with Company B being the
surviving subsidiary.
Company B's financial statements for periods before January 1, 20X2 (the date
common control was established) are not recast. Rather, Company B’s financial
statements for periods before January 1, 20X2 continue to reflect only Company B’s
financial position and results of operations. The historical financial statements of
Company C are combined with those of Company B as of January 1, 20X2.
CONFORMING ACCOUNTING METHODS
28.018 When applying the as-if pooling-of-interests method of accounting for
combinations of entities under common control, the accounting principles used by the
transferring entity may differ from those used by the receiving entity. In this
circumstance, the carrying amounts of the transferred entity may be adjusted to the basis
of accounting used by the receiving entity if the change is preferable under ASC Topic
250. Under ASC paragraph 805-50-30-6, a change in accounting to conform to the
receiving entity’s accounting policies that is determined to be preferable is applied
retrospectively.
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28. Combinations of Entities under Common Control
PRESENTATION OF HISTORICAL EARNINGS PER SHARE
28.019 In an as-if pooling for transactions among entities under common control, the
entities’ balance sheets, results of operations, and cash flows are added together and
reported as if the entities had always been combined (starting with the earliest period that
the entities are under common control). We believe that an entity generally should apply
this same concept to EPS computations. An entity should retrospectively adjust prior
period EPS to reflect the restated income or loss it would have reported in prior periods if
the entities under common control had always been combined, similar to a stock split if
shares are issued to stockholders of the contributing entity.
28.020 Generally, the numerator should equal the sum of the numerators of the combined
entities and the denominator should reflect aggregate adjusted weighted average
outstanding shares, based on equivalent shares of the combined entity. However, if either
of the combined entities have potential common stock, the guidance in ASC paragraph
260-10-55-16 applies and the surviving entity should determine if the retroactive
restatement of income from continuing operations causes potential common stock
originally considered to be dilutive to become antidilutive (or vice versa).
DISTRIBUTION OF CASH OR ASSUMPTION OF LIABILITIES
28.021 In certain situations, cash may be disbursed or liabilities may be assumed in
combinations of entities under common control. Any difference between the amount of
cash disbursed or the fair value of the liabilities assumed and the historical cost of the net
assets acquired is accounted for as an equity transaction (i.e., a dividend or a capital
contribution).
Example 28.5: Accounting for Distribution of Cash or Assumption of
Liabilities
Parent Company owns 100% of the voting stock of Subsidiary A and 60% of the
voting stock of Subsidiary X. Parent Company transfers its 60% interest in Subsidiary
X to Subsidiary A for cash of $220. Parent Company's carrying amount of its
investment in Subsidiary X is $200.
On receipt of Subsidiary X, Subsidiary A should record (1) its investment in
Subsidiary X at $200 (Parent Company's carrying amount) and (2) a dividend to
Parent Company of $20. Parent Company should record a net decrease in its
investment in Subsidiary X of $200, an increase in its investment in Subsidiary A of
$200, and a dividend from Subsidiary A of $20 for the difference between the cash
received of $220 and the carrying amount of its investment in Subsidiary X of $200.
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28. Combinations of Entities under Common Control
COSTS RELATED TO COMBINATIONS OF ENTITIES UNDER
COMMON CONTROL
28.022 Although ASC Subtopic 805-50 is silent regarding the accounting for costs
related to combinations of entities under common control, we believe these costs should
be expensed in the period incurred, unless they relate to the issuance of debt or equity
instruments, in which case they should be accounted for under other applicable guidance.
This is consistent with the principle in a common control transaction that the net assets
received by the entity should be recorded at historical costs (i.e., transferring entity
basis).
28.023 A combining entity that will be merged with entities under common control may
have developed or may intend to develop a plan to integrate the businesses of the
combining entities. That plan may include, among other things, terminating employees,
disposing duplicative facilities, consolidating or relocating equipment and facilities,
integrating information systems, or canceling lease contracts and executory contracts. A
combining entity will recognize as liabilities only those costs that qualify for recognition
if the requirements in ASC Topic 420 are met. For more information on the guidance in
ASC Topic 420, see Section 7.
GOODWILL IMPAIRMENT
28.024 Goodwill presented in the financial statements of entities combined under
common control should continue to be tested for impairment under ASC Topic 350. The
authoritative literature does not provide explicit guidance to determine the reporting units
or the process to test goodwill for impairment with respect to the comparative periods
presented in the receiving entity’s financial statements. In our experience, two methods
have developed in practice.
28.025 The first method continues to use the historical reporting units for the combined
entity, as if the combination under common control had not occurred until the date of the
actual combination (Method A). This method alleviates the need for management to
make hypothetical judgments about the operations and management of the combined
entity for periods preceding the combination. However, this method requires management
to evaluate the reporting structure of the combined entity after the combination. The
guidance in ASC paragraph 350-20-35-45 should be followed to allocate goodwill to
newly identified reporting units on reorganization of the reporting structure:
ASC Paragraph 350-20-35-45
When an entity reorganizes its reporting structure in a manner that changes the
composition of one or more of its reporting units, the guidance in [ASC]
paragraphs 350-20-35-39 through 35-40 shall be used to reassign assets and
liabilities to the reporting units affected. However, goodwill shall be reassigned to
the reporting units affected using a relative fair value allocation approach similar
to that used when a portion of a reporting unit is to be disposed of (see [ASC]
paragraphs 350-20-40-1 through 40-7).
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28. Combinations of Entities under Common Control
28.026 Under the second method, reporting units are identified as if the combination
occurred at the beginning of the earliest period presented (Method B). This method
requires management to make assumptions about how the operations of the combined
entity would have been managed in prior periods as if the entities had been combined in
those periods. This is the case even if doing so is not consistent with how the separate
operations were managed during those periods. A benefit of this approach is that it does
not require a reorganization of the reporting structure at the date of the actual
combination.
Example 28.6: Two Methods of Goodwill Impairment
Method A
Company X was merged into Company Y in a combination of entities under common
control on January 1, 20X4. Before the combination, Company X had one reporting
unit (RU1X) and Company Y had two reporting units (RU1Y and RU2Y). After the
combination, reporting unit RU1X was integrated with reporting units RU1Y and
RU2Y. Company Y (the entity receiving the net assets of Company X) used Method
A to determine its reporting units to test goodwill for impairment after the transaction.
For Company Y’s financial statements for the year ended December 31, 20X4 and its
comparative year ended December 31, 20X3, Company Y identified reporting units
RU1X, RU1Y, and RU2Y to test goodwill impairment for the year ended December
31, 20X3 (period prior to combination). Because goodwill was tested for impairment
(without impairment) at these three reporting units for the year ended December 31,
20X3, no impairment would be recognized for 20X3 in the recast 20X3 financial
statements of Company Y. For the year ended December 31, 20X4, goodwill in
reporting unit RU1X was assigned to reporting units RU1Y and RU2Y based on the
relative fair values of the two portions of reporting unit RU1X prior to those portions
being integrated with reporting units RU1Y and RU2Y, respectively.
Method B
Company X was merged into Company Y in a combination of entities under common
control on January 1, 20X4. Before the combination, Company X had one reporting
unit (RU1X) and Company Y had two reporting units (RU1Y and RU2Y). After the
combination, reporting unit RU1X was integrated with reporting units RU1Y and
RU2Y. Company Y (the entity receiving the net assets of Company X) used Method B
to determine its reporting units to test goodwill for impairment after the transaction.
For Company Y’s financial statements for the year ended December 31, 20X4 and its
comparative year ended December 31, 20X3, Company Y identified reporting units
RU1Y and RU2Y with RU1X integrated amongst RU1Y and RU2Y as if the
operations of RU1X had always been integrated into those reporting units. In order to
assess goodwill impairment, management will need to make assumptions about how
those operations would have been managed before the common control transaction.
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28. Combinations of Entities under Common Control
Depending on the assumptions made, impairment at one or more reporting units could
have been triggered in the historical period.
IDENTIFYING THE PREDECESSOR ENTITY WHEN ENTITIES
ARE NOT UNDER COMMON CONTROL FOR ALL COMPARATIVE
PERIODS
28.027 Identifying the predecessor entity is necessary when the entities included in the
common control transaction were not under common control for all comparative periods
presented. Under ASC paragraph 805-50-45-5, the financial statements of previously
separate entities should not be combined for periods before the date that common control
was established. In the postcombination financial statements, only the predecessor entity
should be included in comparative periods preceding the date that common control
existed. In 2006, the SEC staff commented that the predecessor entity is typically the
entity that was first controlled by the parent entity or control group. In our experience,
this perspective provides a practical approach for identifying the predecessor entity and
prevents the parent entity from using the legal form of the transaction to determine the
financial reporting of the combined reporting entity.
Example 28.7: Identifying the Predecessor Entity
Parent Co. acquired Company Y and Company X on January 1, 20X1 and 20X2,
respectively. Parent Co. transferred Company Y to Company X for cash consideration on
December 31, 20X2.
Q. Which entity is the predecessor entity?
Q. What financial information would be included in the financial statements for
combined Company Y and Company X for the two year period ended December 31,
20X2?
A. Because Company Y was controlled by Parent Co. before Company X, Company Y is
the predecessor entity.
The financial statements of the combined entity for the two years ended December, 31,
20X2 would include the following:
• Financial statements of Company Y for the year ended December 31, 20X1.
Company X’s financial statements are not included for the year ended
December 31, 20X1 because common control of Company X did not exist for
that period.
• Financial statements of Company Y and Company X presented on a
consolidated basis for the year ended December 31, 20X2.
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28. Combinations of Entities under Common Control
28.028 If the entity first controlled by the parent is trivial or otherwise lacks substance, it
may be appropriate to conclude that this entity is not the predecessor. If common control
was established prior to the periods presented in combined financial statements it is
unnecessary to determine the predecessor entity since the financial statements of the
previously separate entities will be combined for all periods presented.
ACCOUNTING AND REPORTING BY THE TRANSFERRING
ENTITY
28.029 ASC Subtopic 805-50 addresses the accounting by the receiving entity in
combinations of entities under common control but does not provide guidance on the
accounting by the transferring entity.
FINANCIAL STATEMENT PRESENTATION OF CONTRIBUTED NET ASSETS OR
EQUITY INTERESTS
28.030 ASC Topic 805 is silent on the accounting by the entity that transfers the net
assets or equity interests. Generally, we believe the transferring entity should report the
transfer as a disposal pursuant to ASC Subtopic 360-10. Under ASC paragraph 360-10-
40-4, “a long-lived asset to be disposed of in an exchange measured based on the
recorded amount of the nonmonetary asset relinquished or to be distributed to owners in a
spinoff is disposed of when it is exchanged or distributed” and should be accounted for as
held and used until such date as provided under ASC paragraph 360-10-45-15. The
transferring entity should continue to classify the asset or asset group as held and used
until it is disposed (i.e., no presentation of discontinued operations prior to disposal). If
the transferring entity distributes the asset or group to owners in a spin-off, that disposal
shall then be reported in discontinued operations if it meets the conditions in ASC
paragraphs 205-20-45-1A through 45-1C.
28.030a Consistent with the accounting and reporting by the receiving entity, if a
transaction between subsidiaries of a common parent represents a transfer of financial
assets, it should be evaluated and accounted for under the guidance in ASC Topic 860.
Evaluating whether a transfer of financial assets between entities under common control
is recognized as a sale under ASC Topic 860 requires careful consideration of the
relationship between the involved parties. See paragraph 860-10-55-78 for additional
application guidance for transfers of financial assets between subsidiaries of a common
parent and paragraph 860-10-55-17D for guidance on transfers from a parent to a
consolidated subsidiary.
28.031 Generally, we do not believe it is appropriate to recast the transferring entity’s
historical financial statements to eliminate the transferred entity from its financial
statements as if the subsidiary had never been owned by the transferring entity (i.e.
retrospective adjustment of prior period financial statements, often referred to as the de-
pooling method). However, in certain limited circumstances in which a common control
transfer of the net assets or equity interests results in a change in reporting entity of the
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28. Combinations of Entities under Common Control
transferring entity, the transferring entity may consider the guidance in ASC paragraph
505-60-S99-1 (SAB Topic 5-Z.7).
28.032 ASC paragraph 505-60-S99-1 addresses whether a company, which disposes of a
business in a spin-off transaction prior to filing an initial registration statement with the
SEC, may characterize the transaction as a change in reporting entity and restate its
financial statements as if the company never had an investment in the disposed of
business. ASC paragraph 505-60-S99-1 provides criteria for considering if there has been
a change in reporting entity by the transferring entity. While ASC paragraph 505-60-S99-
1 does not specifically address transactions between entities under common control, the
criteria may be used in limited circumstances to determine whether a change in reporting
entity has occurred from the transferring entity’s perspective.
28.033 It is important to note that all of the criteria in ASC paragraph 505-60-S99-1 must
be met for the transferring entity to conclude that a change in reporting entity has
occurred. This conclusion may be acceptable if the entities under common control:
• Are dissimilar businesses (dissimilarity is intended to mean substantially
greater differences in the nature of the businesses than those that would
ordinarily distinguish reportable segments as defined by ASC Topic 280);
• Are managed and financed historically as if they were autonomous;
• Have no more than incidental common facilities and costs;
• Will be operated and financed autonomously after the transaction; and
• Will not have material financial commitments, guarantees, or contingent
liabilities to each other after the transaction.
28.034 We believe careful consideration should be applied in determining whether a
change in reporting entity of the transferring entity has truly occurred. If any of the
criteria are not met, the presumption is retrospective adjustment of the prior period
financial statements is ordinarily not appropriate.
RECOGNITION OF DIFFERENCES BETWEEN AMOUNTS CONTRIBUTED AND
PROCEEDS RECEIVED
28.035 Because there has not been a change in basis for the control group, we do not
believe a transferring entity should recognize a gain or loss upon transferring net assets or
equity interests to an entity under common control. A difference between the carrying
amount of net assets transferred and proceeds received, should be recognized by the
transferring entity as an equity transaction (i.e., recognized as a contribution/distribution
from/to shareholders). Recognizing the difference as an equity transaction is consistent
with the guidance in ASC Subtopic 845-10 with respect to nonreciprocal transfers to
owners.
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28. Combinations of Entities under Common Control
ASC Paragraph 810-10-40-5
If a parent deconsolidates a subsidiary or derecognizes a group of assets through a
nonreciprocal transfer to owners, such as a spinoff, the accounting guidance in
[ASC Subtopic 845-10, Accounting for Nonmonetary Transactions,] applies.
Otherwise, a parent shall account for the deconsolidation of a subsidiary or
derecognition of a group of assets specified in [ASC] paragraph 810-10-40-3A by
recognizing a gain or loss in net income attributable to the parent . . . .
ASC Paragraph 845-10-30-10
Accounting for the distribution of nonmonetary assets to owners of an entity in a
spinoff or other form of reorganization or liquidation or in a plan that is in
substance the rescission of a prior business combination shall be based on the
recorded amount (after reduction, if appropriate, for an indicated impairment of
value) (see [ASC] paragraph 360-10-40-4) of the nonmonetary assets distributed.
[ASC] Subtopic 505-60 provides additional guidance on the distribution of
nonmonetary assets that constitute a business to owners of an entity in
transactions commonly referred to as spinoffs. A pro rata distribution to owners of
an entity of shares of a subsidiary or other investee entity that has been or is being
consolidated or that has been or is being accounted for under the equity method is
to be considered to be equivalent to a spinoff. Other nonreciprocal transfers of
nonmonetary assets to owners shall be accounted for at fair value if the fair value
of the nonmonetary asset distributed is objectively measurable and would be
clearly realizable to the distributing entity in an outright sale at or near the time of
the distribution.
28.036 Without authoritative literature specific to the transferring entity, we believe these
paragraphs of ASC Section 845-10-30 provide appropriate guidance. Thus, the
accounting effectively is a reorganization of the mutual parent company. This guidance is
also consistent with the principles of ASC Subtopic 805-50, which specifies that the
acquirer account for a combination of entities under common control at the ultimate
parent’s carrying amount but is silent with respect to the transferring entity’s accounting.
IMPAIRMENT CONSIDERATIONS
28.037 The transferring entity should consider whether the planned transfer indicates that
the assets to be transferred should be tested for recoverability. ASC paragraph 360-10-35-
2 provides circumstances that trigger a recoverability analysis for assets to be held and
used. Paragraph 360-10-35-21(f) states that one of those triggers is “a current expectation
that, more likely than not, a long-lived asset (asset group) will be sold or otherwise
disposed of significantly before the end of its previously estimated useful life.” We
believe many have considered by analogy the guidance in ASC paragraph 360-10-40-4
for combinations of entities under common control.
ASC Paragraph 360-10-40-4
For purposes of [ASC] Subtopic [360-10], a long-lived asset to be disposed of in
an exchange measured based on the recorded amount of the nonmonetary asset
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28. Combinations of Entities under Common Control
relinquished or to be distributed to owners in a spinoff is disposed of when it is
exchanged or distributed. If the asset (asset group) is tested for recoverability
while it is classified as held and used, the estimates of future cash flows used in
that test shall be based on the use of the asset for its remaining useful life,
assuming that the disposal transaction will not occur. In such a case, an
undiscounted cash flows recoverability test shall apply prior to the disposal date.
In addition to any impairment losses required to be recognized while the asset is
classified as held and used, an impairment loss, if any, shall be recognized when
the asset is disposed of if the carrying amount of the asset (disposal group)
exceeds its fair value. The provisions of this Section apply to nonmonetary
exchanges that are not recorded at fair value under the provisions of [ASC] Topic
845.
To the extent that both the transferring and the receiving entities are part of the same
consolidated group, paragraph 360-10-35-21(f) is not applicable for the purpose of
preparing the parent entity's consolidated financial statements, as the transfer does not
represent a disposal from the parent's perspective.
28.038 A loss on disposal is recorded if the fair value of the disposal group that
constitutes a business is less than its carrying amount.
Example 28.8: Trigger for Impairment Evaluation
Background
An entity considers whether to dispose of a business through a transfer to an entity
under common control and, while no final decision has been made, it believes it is
more likely than not that the transfer will occur in the next 12 months.
Q. If an entity expects that it is more likely than not it will transfer a business to an
entity under common control, is that a trigger for impairment evaluation?
A. Yes. ASC paragraph 360-10-35-21 provides the indicators that trigger a
recoverability analysis for assets to be held and used. ASC paragraph 360-10-35-21(f)
states that one of those triggers is “a current expectation that, more likely than not, a
long-lived asset (asset group) will be sold or otherwise disposed of significantly
before the end of its previously estimated useful life.”
ASC paragraph 360-10-40-4 indicates that if an asset to be held and used is tested for
recoverability, the cash flows should be based on the remaining life of the asset,
assuming the disposal transaction will not occur. That paragraph also states that “in
addition to any impairment losses required to be recognized while the asset is
classified as held and used, an impairment loss, if any, shall be recognized when the
asset is disposed of if the carrying amount of the asset exceeds its fair value.”
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28. Combinations of Entities under Common Control
1 Prior to adoption of ASU 2014-09, Revenue from Contracts with Customers, and ASU 2017-05, the Scope
of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets, conveyances of
oil and gas mineral rights and transfers of in-substance real estate are excluded from the guidance on
changes in ownership while the parent maintains control. After adoption of ASU 2014-09 and ASU 2017-
05, conveyances of oil and gas mineral rights and transfers of goods or services to a customer in the scope
of ASC Topic 606 are excluded from this guidance.
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without appropriate professional advice after a thorough examination of the particular situation.
JUNE 2016
APPRAISAL PRACTICES BOARD
VFR VALUATION ADVISORY 2:
THE VALUATION OF
CUSTOMER-RELATED ASSETS
COPYRIGHT © 2016 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
APB VFR Valuation Advisory #2:
The Valuation of Customer-Related Assets
This communication is for the purpose of issuing voluntary guidance on recognized valuation
methods and techniques.
Date Issued: June 15, 2016
Application: Business Valuation, Intangible Assets
Background: Since the Financial Accounting Standards Board (FASB) issued Statement of Financial
Accounting Standards No. 157 (FASB Statement No. 157), predecessor to Accounting Standards
Codification (ASC) 820 Fair Value Measurement (ASC 820), and FASB Statement No. 141(R),
predecessor to ASC 805 Business Combinations, there has been increased interest in the identification
and recognition of the fair value of assets and liabilities in financial statements. Furthermore, the FASB
and the International Accounting Standards Board (IASB) have been working on a convergence project
with an objective of having a consistent set of accounting standards that can be used globally. In that
regard, the IASB has issued International Financial Reporting Standards (IFRS) 3 (revised) Business
Combinations (IFRS 3R), and IFRS 13 Fair Value Measurement, both of which are largely similar to the
same statements issued by the FASB. Accordingly, during the creation of this document, members of the
International Valuation Standards Council (IVSC) reviewed the document and discussed certain topics
with members of this Working Group to try and ensure consistency with both a) valuation concepts in the
International Valuation Standards (IVS) and b) fair value guidance in IFRS 13 that existed at the date of
publication of this document.
Because of the need for financial statements to be both reliable and relevant, valuation practices must
provide reasonably consistent and supportable fair value conclusions. To this end, it is believed that
guidance regarding best practices surrounding certain specific valuation topics would be helpful. The
topics are selected based on those in which the greatest diversity of practice has been observed. To date,
three Working Groups have been sponsored by The Appraisal Foundation. The first Working Group
addressed the topic of contributory assets and charges in a document titled The Identification of
Contributory Assets and Calculation of Economic Rents dated May 31, 2010 (now known as “VFR
Valuation Advisory #1”). The second Working Group has addressed the general topic of customer-related
assets in this document. A third Working Group is addressing the topic of the control premiums as
applied in valuations done for financial reporting purposes. A fourth Working Group is addressing
contingent considerations.
This document is intended to present helpful guidance for those who are preparing fair value
measurements of customer-related assets; however, this paper is not intended to be an authoritative
valuation standard. The Working Group believes that consideration of the facts and circumstances related
to the asset(s) that are being valued may support a departure from the recommendations of this document.
It is the belief of the Working Group that the valuation of assets in general and customer-related assets
specifically is a complicated exercise that requires significant judgment. This paper seeks to present
views on how to approach and apply the valuation process appropriate for customer-related assets.
The Appraisal Practices Board and The Appraisal Foundation wish to express our utmost gratitude to the
Working Group on Customer-Related Assets for volunteering their time and expertise in contributing to
this document. Specifically, sincere thanks to the following individuals:
Working Group on Customer-Related Assets
Dan Knappenberger, Chair
Deloitte Transactions and Business Analytics
LLP –
San Jose, CA
Christopher Armstrong
KPMG LLP – Los Angeles, CA
PJ Patel
Valuation Research Corporation – Princeton, NJ
Peter Wollmeringer
Huron Consulting Group– New York, NY
Justin Kloos, Technical Writer
Duff & Phelps, LLC – Atlanta, GA
Carla Glass, Steering Committee Oversight &
Facilitator
Meyers, Harrison and Pia, LLC – New Haven,
CT
Subject Matter Expert Group on Best Practices for Valuations in Financial Reporting
Jay E. Fishman, Co-Chair - Financial Research
Associates
Carla G. Glass, Co-Chair - Meyers, Harrison
and Pia, LLC
Anthony Aaron - Ernst & Young LLP
Paul Barnes - Duff & Phelps, LLC
John Glynn - PricewaterhouseCoopers LLP
Lee Hackett - Retired
Matt Pinson - PricewaterhouseCoopers LLP
Contributors & Special Thanks
Aaron Gilcreast, PricewaterhouseCoopers LLP
Ed Hamilton, Valuation Research Corporation
Greg Forsythe, Deloitte Financial Advisory Services LLP, IVSC Liaison
Alok Mahajan, KPMG, LLP, APB Liaison
Adriana Berrocal, Building Value Consulting, SC, APB Liaison
Appraisal Practices Board Members (July 2015 – June 2016)
Rick O. Baumgardner, Chair
Shawn Wilson, Vice Chair
Adriana Berrocal
Lisa Desmarais
Ernest Durbin
Jay E. Fishman
Guy Griscom
Donna VanderVries
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
© 2016 The Appraisal Foundation
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The Appraisal Foundation Staff
David Bunton, President
John S. Brenan, Director of Appraisal Issues
Paula Douglas Seidel, Executive Administrator
Staci Steward, Appraisal Practices Board Administrator
The views set forth in this exposure draft are the collective views of the members of this Working
Group and do not necessarily reflect the views of any of the firms that the Working Group members
are associated with.
The Appraisal Foundation served as a sponsor and facilitator of this Working Group. The
Foundation is a non-profit educational organization dedicated to the advancement of professional
valuation and was established in 1987 by the appraisal profession in the United States. The Appraisal
Foundation is not an individual membership organization, but rather an organization that is made up
of other organizations. Today, over 110 non-profit organizations, corporations and government
agencies are affiliated with The Appraisal Foundation. The Appraisal Foundation is authorized by
the US Congress as the source of appraisal standards and qualifications.
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
© 2016 The Appraisal Foundation
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Table of Contents
1.0
INTRODUCTION ............................................................................................................................................................ 6
2.0 ACCOUNTING BACKGROUND AND OVERVIEW ................................................................................................. 8
2.1 Accounting Standards and the Accounting Standards Codification .............................................................................. 8
2.2 Business Combinations .................................................................................................................................................. 9
2.3 Asset Acquisitions ....................................................................................................................................................... 10
2.4 Goodwill and Indefinite-Lived Asset Impairment Testing .......................................................................................... 10
2.5 Long-Lived Asset Impairment Testing ........................................................................................................................ 11
3.0
IDENTIFICATION OF CUSTOMER-RELATED ASSETS AND VALUE CONSIDERATIONS........................ 14
Introduction ................................................................................................................................................................. 14
3.1
3.2
Identification of Customer-Related Assets .................................................................................................................. 14
3.3 Value Considerations ................................................................................................................................................... 17
4.0 VALUATION METHODOLOGIES ............................................................................................................................ 21
Introduction ................................................................................................................................................................. 21
4.1
4.2
Income Approach ........................................................................................................................................................ 21
4.3 Cost Approach ............................................................................................................................................................. 22
4.4 Market Approach ......................................................................................................................................................... 22
5.0 APPLICATION OF THE INCOME APPROACH ..................................................................................................... 24
5.1
Introduction ................................................................................................................................................................. 24
5.2 Multi-Period Excess Earnings Method (MPEEM) ...................................................................................................... 24
5.3 Distributor Method ...................................................................................................................................................... 39
5.4 With-and-Without Method .......................................................................................................................................... 42
5.5 Cost Savings Method ................................................................................................................................................... 47
6.0 APPLICATION OF THE COST APPROACH ........................................................................................................... 49
6.1
Introduction ................................................................................................................................................................. 49
6.2 Cost Approach ............................................................................................................................................................. 50
7.0 APPLICATION OF THE MARKET APPROACH .................................................................................................... 54
Introduction ................................................................................................................................................................. 54
7.1
7.2 Methodology ................................................................................................................................................................ 54
8.0 VALUATION METHODOLOGY SELECTION........................................................................................................ 55
9.0 OTHER CONSIDERATIONS ...................................................................................................................................... 58
9.1
Introduction ................................................................................................................................................................. 58
9.2 Backlog ........................................................................................................................................................................ 58
9.3 Deferred Revenue ........................................................................................................................................................ 58
9.4 Step-Up Considerations for Inventory ......................................................................................................................... 62
9.5 Overlapping Customers ............................................................................................................................................... 66
9.6 Pre-Existing Relationships in a Business Combination ............................................................................................... 66
9.7 Asset Life and Amortization ........................................................................................................................................ 67
9.8 Testing Outputs ............................................................................................................................................................ 70
10.0
11.0
12.0
13.0
SUMMARY ................................................................................................................................................................ 73
LIST OF ACRONYMS USED .................................................................................................................................. 74
REFERENCES .......................................................................................................................................................... 76
GLOSSARY ............................................................................................................................................................... 78
13.1
13.2
Glossary of Terms ................................................................................................................................................... 78
Glossary of Entities Referred to in Document ........................................................................................................ 82
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
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APPENDIX A: ATTRITION RATE CALCULATION EXAMPLES ............................................................................... 83
APPENDIX B: CASE STUDY EXAMPLES ........................................................................................................................ 98
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
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1
1.0
INTRODUCTION
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1.1.1 This document (Valuation for Financial Reporting Advisory #2), entitled The Valuation of
Customer-Related Assets, is the result of deliberations by the Working Group on Customer-Related Assets
(the second Working Group in the “Best Practices for Valuations in Financial Reporting: Intangible Asset
Working Group” series) and was developed with input received from interested parties. Customer-related
assets include customer lists, order or production backlog, customer contracts and related relationships,
and non-contractual customer relationships. The purpose of this Valuation Advisory is to outline best
practices in the valuation of customer-related assets for financial reporting purposes.
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1.1.2 There are multiple situations that may require the valuation of customer-related assets for financial
reporting purposes, including but not limited to:
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a. Business combinations;
b. Asset acquisitions;
c. Goodwill impairment testing;
d. Long-lived asset impairment testing; and
e. Reorganizations (i.e., fresh-start accounting).
1.1.3 The approaches and methodologies used to value customer-related assets under each of the
situations above are similar. Additionally, the situations outlined above are similar in that they focus on a
valuation of only the customer-related assets of a business (i.e., existing customers) that meet the
identification and recognition criteria (which are discussed in this document) at the effective date of the
valuation. Future customer-related assets, which do not meet the identification and recognition criteria, are
not included in these analyses. The majority of the accounting guidance is contained in the Financial
Accounting Standards Board (FASB) Accounting Standards CodificationTM (ASC) and the International
Financial Reporting Standards (IFRSs).
1.1.4 The following discussion on the valuation of customer-related assets for financial reporting
purposes requires an understanding of relevant accounting and valuation concepts. In-depth discussion of
these concepts is beyond the scope of this Valuation Advisory and the reader is assumed to have a general
understanding of these concepts. Specifically, the reader is assumed to have knowledge of relevant
accounting and valuation concepts as they relate to the valuation of assets and liabilities for financial
reporting purposes outlined above in paragraph 1.1.2.
1.1.5 The Working Group recognizes professional judgment is critical in effectively planning,
performing, and concluding a valuation. Professional judgment requires fact gathering, research, and
analysis to reach well-reasoned conclusions based on relevant facts and circumstances available at the
time. Due to the nature of judgments, questioning and skepticism are appropriate. Even then,
knowledgeable, reasonable, objective individuals can reach different conclusions for a given set of facts
and circumstances.
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1.1.6 The following important clarifications regarding this document are also made:
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
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a. These best practices have been developed with reference to United States (US) Generally Accepted
Accounting Principles (GAAP) and IFRSs effective as of the date this document was published.1
While the Working Group believes the best practices described herein may have application
outside of US GAAP and IFRSs, valuation specialists should not apply these best practices to
valuations prepared under different standards/statutory requirements without a
thorough
understanding of the differences between those standards and US GAAP and IFRSs existing as of
the date of this publication;
b. The Working Group has not used the terms “cash flow,” “earnings,” and “income” as commonly
used in the accounting literature. When these and similar terms are used, they will refer to an
“economic earnings” concept associated with the netting of expense and other charges against
revenue;
c. The terms “value,” “valuation,” “valuing,” “fair value,” and any other reference to value
throughout this document are intended, for the purposes of this document, to be stated in
accordance with “fair value” as defined in ASC and IFRSs;
d. The discussions and examples in this Valuation Advisory make specific assumptions for
illustrative purposes only. While general principles have been provided for guidance to assist in the
valuation of customer-related assets, assumptions used in the valuation of any asset should be
based on facts and circumstances; and
e. The models used in the sample calculations are for illustrative purposes only and are not intended
to represent the only form of model, calculation, or final report exhibit that is generally considered
acceptable among valuation specialists.
1.1.7 This document provides detail related to valuation techniques that are used to value customer-
related assets for accounting-related purposes. The paper includes detailed discussion of the following
topics:
a. Definitions of customer-related assets as set out in accounting literature and an exploration of the
economic characteristics of customer-related assets;
b. Valuation techniques used to estimate the fair value of customer-related assets that are viewed to
be representative of best practice; and
c. How customer-related assets interact with other assets of a business and best practice guidance on
how to address these relationships in fair value measurements.
1.1.8 The appendices at the end of this Valuation Advisory include examples of several techniques and
methodologies relevant to the valuation of customer-related assets. Each example provides a set of facts
and circumstances to demonstrate the associated valuation techniques discussed.
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1 IFRS 13 Fair Value Measurement was issued in May 2011 with an effective date of January 1, 2013.
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2.0
ACCOUNTING BACKGROUND AND OVERVIEW
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2.1 Accounting Standards and the Accounting Standards Codification
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2.1.1 In 2001, the FASB issued several accounting standards to address business combinations, intangible
assets and goodwill, and impairment testing guidance: Statement of Financial Accounting Standards No.
141, Business Combinations (FASB Statement No. 141); Statement No. 142, Goodwill and Other
Intangible Assets (FASB Statement No. 142); and Statement No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets (FASB Statement No. 144). FASB Statement No. 141 required that certain
assets acquired in a business combination be recorded at fair value. FASB Statement No. 142 and FASB
Statement No. 144 address asset impairment.
2.1.2 In 2006, the FASB issued Statement No. 157, Fair Value Measurements (FASB Statement No.
157), to provide a uniform definition of fair value and a framework for developing fair value
measurements. Subsequently, in 2007, as part of the joint development project between the FASB and the
International Accounting Standards Board (IASB), the FASB issued a revised version of FASB Statement
No. 141 (FASB Statement No. 141R). FASB Statement No. 141R and International Financial Reporting
Standard 3 (revised), Business Combinations (IFRS 3R), are largely similar, although some differences
exist.
2.1.3 On July 1, 2009, the FASB changed the way accounting standards are organized and accessed.
FASB ASC is now the single source of authoritative US GAAP. ASC does not change US GAAP;
however, it combines all authoritative accounting standards issued by bodies such as the FASB, the
American Institute of Certified Public Accountants (AICPA), and the Emerging Issues Task Force (EITF)
into a topically organized database. ASC supersedes all existing US accounting literature (other than
additional guidance issued by the Securities and Exchange Commission [SEC]). Primary reference
changes relevant to this document due to ASC are as follows:
a. FASB Statement No. 141R ASC 805, Business Combinations
b. FASB Statement No. 142 ASC 350, Intangibles—Goodwill and Other
c. FASB Statement No. 144 ASC 360, Property, Plant, and Equipment
d. FASB Statement No. 157 ASC 820, Fair Value Measurement
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2.1.4 With limited exceptions, ASC 805 and IFRS 3R both require that assets and liabilities acquired in a
business combination be measured at fair value. As mentioned above, under US GAAP and IFRSs, fair
value measurement guidance is addressed in ASC 820 and IFRS 13, respectively.
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2.1.5 Both ASC 805 and IFRS 3R pay a significant amount of attention to intangible assets in discussion
and examples, particularly for customer-related assets. International Accounting Standard 38, Intangible
Assets (IAS 38) and the illustrative examples in IFRS 3R address the identification of intangible assets
under IFRS and provide guidance on the nature of customer-related assets.
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2.1.6 In May 2011, the FASB updated ASC 820, Fair Value Measurement via Accounting Standards
Update (ASU) 2011-4, in tandem with the IASB issuing, for the first time, IFRS 13 Fair Value
Measurement. IFRS 13 is virtually identical to ASC 820, although some minor differences exist; however,
the principles of measuring fair value are identical between IFRS 13 and ASC 820.
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2.2 Business Combinations
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2.2.1 In a business combination, ASC 805 and IFRS 3R require the recognition and measurement of the
fair value (with limited exceptions) of identifiable assets acquired (including current, financial, fixed, and
intangible assets), liabilities assumed (including current and financial liabilities), and consideration
transferred (e.g., contingent consideration).
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2.2.2 Fair value is defined in the ASC 820 Glossary2 and IFRS 13 (9)3 as “the price that would be
received to sell an asset or paid to transfer a liability in an orderly transaction between market participants
at the measurement date.”
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2.2.3 ASC 805 and IFRS 3R require that identifiable intangible assets be recognized at fair value
separately from goodwill. For example, ASC 805-20-20 outlines the following: “An asset is identifiable if
it meets either of the following criteria: (a) It is separable, that is, capable of being separated or divided
from the entity and sold, transferred, licensed, rented, or exchanged, either individually or together with a
related contract, identifiable asset, or liability, regardless of whether the entity intends to do so, or (b) It
arises from contractual or other legal rights, regardless of whether those rights are transferable or
separable from the entity or from other rights and obligations.” IFRS 3R outlines similar criteria. An asset
may also meet the separable criteria if it cannot be sold, licensed, or exchanged individually, but could be
when combined with a related contract, asset, or liability (ASC 805-20-55-5). Although ASC 805 and
IFRS 3R do not provide specific guidance to determine whether an asset arises from contractual or legal
rights, the Working Group believes the criteria for recognition is intended to be broad. Specific examples
of intangible assets that meet the recognition criteria are discussed in ASC 805-20-55-11 to 55-45 and 55-
52 to 55-57, and in paragraphs IE16-44 of IFRS 3R. It should be noted that these lists, which include
customer-related assets, are not intended to be all-inclusive.
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2.2.4 Fair values are estimated using three generally accepted valuation approaches that are set out in
ASC 820 and IFRS 13 as the income, cost, and market approach. A determination must be made as to the
appropriate methodology or methodologies to estimate the fair value of each type of asset, liability, and
non-controlling interest and/or previously held equity interest.
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2.2.5 In December 2014, FASB issued new accounting guidance for business combinations for private
companies. FASB ASU No. 2014-18, Business Combinations—Accounting for Identifiable Assets in a
Business Combination, a Consensus of the Private Company Council, offers private companies an
alternative for the recognition of customer-related assets and non-competition agreements. The accounting
alternative applies when an entity within the scope of the ASU is required to recognize or otherwise
consider the fair value of intangible assets as a result of certain in-scope transactions, which includes ASC
805 and ASC 852 (fresh-start reporting).
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2.2.6 The main provisions of the ASU allow an entity to elect the accounting alternative to no longer
recognize separately from goodwill “1) customer-related assets unless they are capable of being sold or
licensed independently from the other assets of the business, and 2) noncompetition agreements.” 4 An
entity that elects the accounting alternative must also adopt the private company alternative to amortize
goodwill as set out in FASB ASU No. 2014-12, Intangibles – Goodwill and Other (Topic 350). However,
2 Financial Accounting Standards Board, Accounting Standards Codification™ (2009).
3 IFRS Foundation, IFRS 13 Fair Value Measurement (London: 2011).
4 Financial Accounting Foundation, Accounting Standards Update No. 2014-18 (Norwalk, CT: 2014).
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an entity that adopts ASU 2014-12 is not required to adopt ASU 2014-18. The ASU, if elected, is effective
in fiscal years beginning after December 15, 2015, and early application is permitted for any interim and
annual financial statements that have not yet been made available for issuance.
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2.2.7 The Working Group believes that the election of the ASU will result in companies most likely
recording more goodwill than in the past, which would then have to be amortized over a period of ten
years or less. In addition, it appears that the entities that are most likely to elect the ASU are entities that
do not plan to become publicly traded entities, as upon becoming public the financial statements would
have to be restated to reflect the accounting in place had the ASU not been elected.
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2.3 Asset Acquisitions
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2.3.1 ASC 805-20-20 defines a business as "an integrated set of activities and assets that is capable of
being conducted and managed for the purpose of providing a return in the form of dividends, lower costs,
or other economic benefits directly to investors or other owners, members or participants.”5 The definition
is further outlined in ASC 805-10-55-4 through 55-9 and in IFRS 3R (B7 – B12).
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2.3.2 ASC 805-50-30-1 to 30-4 addresses the acquisition of assets rather than a business (also addressed
in IFRS 3R [2b]). An acquisition of assets or groups of assets that do not meet the definition of a business
is initially recognized at its cost to the acquiring entity (it should be noted that the Working Group
observes that many acquisitions of groups of assets meet the definition of a business and would therefore
be accounted for as a business combination). Acquiring assets in groups requires not only ascertaining the
cost of the asset (or net asset) group but also allocating that cost to the individual assets (or individual
assets and liabilities) that comprise the group. The cost of a group of assets acquired in an asset acquisition
is allocated to the individual assets acquired or liabilities assumed based on their relative fair values and
does not give rise to goodwill. Similar to asset valuations performed in relation to a business combination,
the fair values of all the individual assets included in an asset acquisition (including customer-related
assets) should be estimated according to the fair value principles outlined in ASC 820 and IFRS 13. Since
goodwill does not arise in a purchase of assets that are not a business, relative fair value adjustments may
be required, resulting in asset values that do not necessarily equal their fair values.
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2.4 Goodwill and Indefinite-Lived Asset Impairment Testing
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2.4.1 ASC 350 addresses impairment testing under US GAAP of indefinite-lived intangible assets and
goodwill.6 For public entities, ASC 350 outlines a two-step impairment test for goodwill. The first step
involves estimating the fair value of a reporting unit. If the test indicates that the fair value of the reporting
unit is less than the carrying amount, this indicates that an impairment may exist and that a second step
test should be performed. Under the second step, the fair value of goodwill is estimated using the fair
value of the reporting unit as previously determined and the guidance set forth in ASC 805 regarding the
valuation of the assets and liabilities of the reporting unit. Therefore, the business combination valuation
process as outlined in ASC 805 (which may involve the valuation of customer-related assets) is applicable
to the ASC 350 step two test for goodwill impairment.
5 Accounting Standards Codification™ 805-20-20.
6 FASB issued an Accounting Standards Update (ASU) No. 2014-02 in January 2014 titled Intangibles-Goodwill and Other
(Topic 350) Accounting for Goodwill, a Consensus of the Private Company Council which deals with the accounting of
goodwill for private companies.
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2.4.2 International Accounting Standard 36, Impairment of Assets (IAS 36), addresses impairment testing
of certain non-financial assets and goodwill under a model that is different than the model outlined in US
GAAP. An asset is tested for impairment either on its own or as part of a cash-generating unit (CGU),
which is defined in IAS 36 as the smallest group of assets that generates cash inflows from continuing use
that are largely independent of the cash inflows from other assets or groups of assets. Based on the
definition, a CGU may be at a different level than a reporting unit. Impairment exists when the carrying
amount of an asset or CGU exceeds its recoverable amount. The recoverable amount is the greater of its
fair value less costs of disposal and its value in use. The impairment model under IAS 36 is a single step
test and accordingly an impairment is recognized as the amount by which the carrying amount of an asset
or CGU exceeds its recoverable amount. The impairment model for goodwill under IAS 36 does not
include the second step test that is applied under US GAAP when the fair value of a reporting unit is
below its carrying amount, nor does it limit the impairment loss to the carrying amount of goodwill. Under
IAS 36, an impairment loss is allocated first to reduce goodwill to zero, then, subject to certain limitations,
the carrying amount of other assets in the CGU (that are within the scope of IAS 36) are reduced pro rata
based on the carrying amount of each asset.
2.4.3 While fair value less costs of disposal is a well-understood concept, value in use (VIU) is a
measurement basis that is only applied in impairment testing under IFRSs. As an IFRS-specific
measurement, IAS 36 prescriptively describes how VIU is to be measured using discounted cash flow
techniques. For example, IAS 36 (30-57) states that "estimates of future cash flows include: a) projections
of cash inflows from the continued use of the asset; b) projections of cash flows that are necessarily
incurred to generate the cash inflows from the continued use of the asset (including cash outflows to
prepare the asset for use) and can be directly attributed, or allocated on a reasonable and consistent basis,
to the asset; and c) net cash flows, if any, to be received or paid for the disposal of the asset at the end of
its useful life."7 The standard notes that future cash flows should not include cash flows that arise from
restructurings that have not yet been committed, improvements or enhancements to the asset, or cash
generating unit's performance. VIU uses entity-specific cash flows as opposed to fair value, which uses
market participant cash flows.
2.4.4 ASC 350 and IAS 36 both address impairment of indefinite-lived intangible assets other than
goodwill via a single step test. Impairment arises if the carrying amount of the indefinite-lived intangible
asset (or, if applicable, CGU under IAS 36) exceeds the fair value or the greater of fair value less costs of
disposal or value in use under IAS 36.8 Indefinite-lived intangible assets, which typically include certain
trade names, trademarks, and brands, as well as in-process research and development (IPR&D) or other
intangible assets that are not yet available for use, are required to be tested annually and upon the
occurrence of a triggering event.9 In the Working Group’s view, customer-related assets generally would
not qualify as an indefinite-lived asset.
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2.5 Long-Lived Asset Impairment Testing
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2.5.1 ASC 360 addresses impairment testing for long-lived assets held and used or assets held for sale or
disposal upon a triggering event. ASC 360 uses a recoverability test to determine if the carrying amount of
7 International Accounting Standards Committee Foundation, International Accounting Standard 36: Impairment of Assets
(London: 2008).
8 The fair value guidance under IFRS 13 does not apply to the "value in use" measure as described in IAS 36.
9 In-process R&D or intangible assets that are not yet available for use are not indefinite-lived, but are treated in the same
manner as indefinite-lived assets.
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a held and used asset or asset group is recoverable. If the asset or asset group is not recoverable, fair value
measurements are used to determine the amount of impairment. ASC 360-10-20 defines an asset group as
the unit of accounting for a long-lived asset or assets to be held and used, which represents the lowest
level for which identifiable cash flows are largely independent from the cash flows of other groups of
assets and liabilities. This is typically measured based on cash flows that the asset or asset group would
generate over the remaining useful life of the asset or the primary asset10 in the asset group. The
recoverability test compares the sum of the undiscounted cash flows of the asset or asset group to the
carrying amount of the asset or asset group. If the carrying amount exceeds the undiscounted cash flows,
there is a second step test in which the fair value of the asset group, which may include customer-related
assets, is estimated for the purpose of estimating the amount of impairment. ASC 360-10-35-28 states,
“An impairment loss for an asset group shall reduce only the carrying amounts of a long-lived asset or
assets of the group. The loss shall be allocated to the long-lived assets of the group on a pro rata basis
using the relative carrying amounts of those assets, except that the loss allocated to an individual long-
lived asset of the group shall not reduce the carrying amount of that asset below its fair value whenever
that fair value is determinable without undue cost and effort.”11
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2.5.2 As noted in 2.4.2, IAS 36 covers impairment for both long-lived assets and goodwill using a one-
step recoverability test.
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2.5.3 Under US GAAP, there is an order for impairment testing (assuming the assets are not held for sale)
where indefinite-lived assets should be tested under ASC 350 first, then long-lived assets tested under
ASC 360, and lastly goodwill tested under ASC 350 (ASC 350-20-35-31). It is important to use the
adjusted balance sheet carrying amounts as a result of each preceding test. In other words, if an indefinite-
lived asset was impaired, the impairment amount may impact the carrying amount of the ASC 360 asset
group and/or the ASC 350 reporting unit carrying amount. Similarly, if a long-lived asset was impaired,
the impairment amount may impact the ASC 350 reporting unit carrying amount.
2.5.4 Under IAS 36, similar to US GAAP,12 individual assets (both finite and indefinite-lived) are tested
for impairment prior to testing goodwill for impairment. If an asset is impaired, the amount is adjusted in
the CGU prior to the goodwill impairment test being applied. In many cases, when an individual asset’s
recoverable amount cannot be estimated, it is tested as part of the CGU. If there is impairment at the CGU
level, the amount is first applied to goodwill with any remaining impairment applied to other assets in the
scope of IAS 36 on a pro-rata basis. IAS 36 does not permit an asset’s carrying amount to be written down
below the higher of fair value less costs of disposal (if determinable), value in use (if determinable), and
zero.
2.5.5. IAS 36 also requires entities to assess whether there is any indication that an impairment loss
recognized in prior periods for an asset other than goodwill or a CGU (not applicable to goodwill) may no
longer exist or may have decreased (IAS 36.110-125). If it has been determined that the value of the asset
has increased, the previously recognized impairment is required to be reversed in full (which would be
unusual) or in part. Where the reversal applies to a CGU, the carrying amounts other than goodwill would
be increased on a pro-rata basis, but not to exceed the pre-impairment amount—i.e., the amount at which
10 The term “primary asset” as used here is in the context of accounting terminology and guidance and is not necessarily
equivalent to the term as used elsewhere in this Valuation Advisory in the context of the relative value and importance of assets
to a business.
11 Accounting Standards Codification™ 360-10-35-28.
12 Under US GAAP, finite-lived assets are only tested upon a triggering event.
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the asset would have been recorded if no impairment was taken. For example, for an asset with a finite
life, if impairment was recorded two years prior, one could not write the asset back to the pre-impairment
amount, but rather to that amount less two years of additional amortization.
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3.0 IDENTIFICATION OF CUSTOMER-RELATED ASSETS AND VALUE
CONSIDERATIONS
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3.1 Introduction
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3.1.1 When valuing customer-related assets, the Working Group believes that asset identification and
qualitative considerations are equally as important as the selection of valuation methodology and other
quantitative factors. This section provides an overview of issues to consider when identifying customer-
related assets and qualitative considerations that will assist in assessing the relative importance of
customer-related assets compared to other assets present in an entity. These qualitative factors are critical
to the valuation process and should be continually revisited throughout the valuation analysis.
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3.2 Identification of Customer-Related Assets
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3.2.1 Since the issuance of ASC 805's predecessor standard (i.e., FASB Statement No. 141) and ASC
350’s predecessor standard (i.e., FASB Statement No. 142), customer-related assets have been the subject
of additional guidance from the FASB and SEC. Specifically, the FASB's EITF clarified the identification
and recognition criteria for customer-related assets in EITF Issue 02-17, Recognition of Customer
Relationship Intangible Assets Acquired in a Business Combination (FASB Statement No. 141R nullified
the EITF and incorporated the guidance in the standard), and FASB Staff Position (FSP) Financial
Accounting Standard (FAS) 142-3, Determination of the Useful Life of Intangible Assets (also nullified
and incorporated into ASC 350). In addition, the SEC staff has discussed the topic of customer-related
assets in speeches. Although not authoritative, these efforts were aimed at clarifying the implementation
guidance in the accounting standards as well as addressing interpretation and practice diversity issues.
3.2.2 Customer-related assets, like other intangible assets, must meet certain recognition criteria to be
considered identifiable for financial reporting purposes. ASC 805 continues the guidance set forth in prior
US GAAP where identifiable assets are recognized if they are contractual, arise from legal rights, or if
they are separable and can be separated and sold, rented, or leased (ASC 805-20-25-10, IFRS 3R
(Appendix A), and B31). An intangible asset may be separately recognized even if the asset is subject to
transfer restrictions or the contract is subject to a cancellation option. However, the impact of these
features may affect the fair value of the intangible asset.
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3.2.3 Certain customer-related intangible assets may not require recognition separate from goodwill since
they fail to meet the contractual-legal or separability criteria. An example of such assets includes walk-in
customers (which are described later in paragraph 3.2.14).
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3.2.4 ASC 805 and IFRS 3R identify several types of customer-related intangible assets that require
separate recognition in a business combination, including customer contracts and related relationships,
non-contractual customer relationships, order or production backlog, and customer lists. These customer-
related assets are defined and/or described in ASC 805-20-55-20 to 28 and in IFRS 3R (IE23-IE31).
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3.2.5 ASC 820 and IFRS 13 specify that fair value should represent the attributes of the asset from the
perspective of a market participant. For example, if there is a legal restriction on the use or sale of an
asset, those facts should be considered in the measurement. However, if the restriction is an attribute of
the holder of the asset rather than of the asset itself, such a restriction would be excluded from the fair
value consideration if other potential market participants would be able to access and use the asset without
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restriction. For example, the holder of an asset may be restricted from fully utilizing it by government
regulations driven by competition concerns. However, other market participants with a lesser market share
may not be restricted in the same manner and may be able to realize a greater value from the asset.
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3.2.6 The accounting literature provides guidance related to the different categories of customer-related
assets as described in the following paragraphs:
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a. A Customer List “consists of information about customers, such as their names and contact
information. A customer list also may be in the form of a database that includes other information
about the customers, such as their order histories and demographic information. A customer list
generally does not arise from contractual or other legal rights. However, customer lists are
frequently leased or exchanged. Therefore, a customer list acquired in a business combination
normally meets the separability criterion” IFRS 3R [IE24]).13 Examples of customer lists may
include prescription files, subscriber lists, or frequent flyer/loyalty programs.
b. An Order or Production Backlog “arises from contracts such as purchase or sales orders. An order
or production backlog acquired in a business combination meets the contractual-legal criterion
even if the purchase or sales orders can be cancelled” IFRS 3R [IE25]).14 As described above, the
ability to cancel sale or purchase orders does not impact whether the order or production backlog
should be recognized separately as an intangible asset, although it may impact its fair value
measurement.
c. Customer Contracts and the Related Customer Relationships are identified because “if an entity
establishes relationships with its customers through contracts, those customer relationships arise
from contractual rights. Therefore, customer contracts and the related customer relationships
acquired in a business combination meet the contractual-legal criterion, even if confidentiality or
other contractual terms prohibit the sale or transfer of the contract separately from the acquiree”
IFRS 3R [IE26]).15 As described above, the ability to cancel a contract or the fact that the contract
is subject to transfer restrictions does not impact whether the customer contract should be
recognized separately as an intangible asset, although it may impact its fair value measurement. It
should also be noted that customer contracts that are deemed to be unfavorable to market terms
may give rise to a liability (see ASC 805-20-55-31, IFRS 3R [IE34]).
3.2.7 The Working Group believes the best practice is the identification of customer-related assets that
include the value arising from the existing contractual period as well as any value arising from
probability-adjusted post-contract expected renewals. There are situations when it may be more intuitive
to measure the two components separately (for example, when a single customer has pre-existing orders as
part of a backlog asset and future orders are part of the ongoing customer relationship asset); however,
even in cases where the components are measured separately, the combined asset value may be recognized
as a single asset (unit of account). It should be noted that certain international and tax reporting guidelines
may support the separate recognition of the two components.
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3.2.8 A Customer Relationship is defined as a relationship that
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exists between an entity and its customer if the entity has information about the customer and has regular
contact with the customer, and the customer has the ability to make direct contact with the entity. Customer
13 Accounting Standards Codification™ 805-20-55-21.
14 Accounting Standards Codification™ 805-20-55-22.
15 Accounting Standards Codification™ 805-20-55-23.
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relationships meet the contractual-legal criterion if an entity has a practice of establishing contracts with its
customers, regardless of whether a contract exists at the acquisition date. Customer relationships also may arise
through means other than contracts, such as through regular contact by sales or service representatives. As noted
in paragraph 805-20-55-22, an order or production backlog arises from contracts such as purchase or sales
orders and therefore is considered a contractual right. Consequently, if an entity has relationships with its
customers through these types of contracts, the customer relationships also arise from contractual rights and
therefore meet the contractual-legal criterion.16 (a similar definition is also found in IFRS 3R [IE28]).
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3.2.9 Non-Contractual Customer Relationships are discussed in the following paragraphs, including
statements in ASC 805, IFRS 3R, and their respective examples.
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3.2.10 ASC 805 and IFRS 3R indicate that
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a customer relationship acquired in a business combination that does not arise from a contract may
nevertheless be identifiable because the relationship is separable. Exchange transactions for the same asset or a
similar asset that indicate that other entities have sold or otherwise transferred a particular type of
noncontractual customer relationship would provide evidence that the noncontractual customer relationship is
separable. For example, relationships with depositors are frequently exchanged with the related deposits and
therefore meet the criteria for recognition as an intangible asset separately from goodwill.17 Part referenced in
IFRS 3R [IE31].
3.2.11 An example of non-contractual customer relationships that typically do not meet the recognition
criterion are customers who frequent retail stores but do not participate in the loyalty program of the store
(i.e., walk-in customers). These customers generally do not meet the definition of a customer-related asset
because the entity possesses limited identifying information and the customer does not enter into a
contract. These walk-in customers typically are not recognized as assets as they fail to meet the
recognition criteria. In some cases, where information is exchanged between the entity and the customer, a
customer list may meet the separability criteria and have value. This often occurs with retailers who offer
loyalty programs that enable the retailer to retain information about walk-in customers, thus meeting the
recognition criteria (separability).
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3.2.12 Some entities offer loyalty programs to incentivize customers to continue to shop at the store or use
services (i.e., airlines and hotels). IFRS Interpretations Committee Interpretation (“IFRIC”) 13, Customer
Loyalty Programmes, addresses customer loyalty programs from the perspective of recognizing revenue or
a liability related to an obligation to fulfill the award. However, it does not address whether non-
contractual customers of an entity would be recognized as a result of the program.
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3.2.13 Under US GAAP, there is limited guidance as to whether customers enrolled in loyalty programs
represent customer-related assets. The Working Group believes that when the arrangement is with a store,
such as a grocery store, the intangible asset would most likely be a customer list. Such lists are generally
separable, although each situation should be examined to determine if it meets the appropriate recognition
criteria. Other programs that are arranged through credit cards, frequent flyer programs, and hotel
programs may meet the contractual-legal criteria to have separate recognition. Such programs appear to
represent an asset and a conditional obligation (e.g., liability) on the part of an entity to provide additional
economic value to its customers beyond the service or goods purchased by the customers.
16 Accounting Standards Codification™ 805-20-55-25.
17 Accounting Standards Codification™ 805-20-55-27.
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3.2.14 Once general categories of customer relationships are identified, it may be necessary to
disaggregate them further according to differences in various customer attributes. For example, customer
relationships may differ based on the products they purchase or characteristics such as profit margins,
attrition patterns, geographic locations, sizes, etc. In these cases, it may be appropriate to value these
customer-related assets separately. Such characteristics may also have an impact on the methodology
chosen and inputs used in the valuation of the customer-related assets.
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3.3 Value Considerations
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3.3.1 In valuing customer-related assets, the valuation specialist should consider aspects of both the
quantitative and the qualitative importance of the customer-related assets, including the importance of the
customer-related asset itself, the importance of the customer-related asset to the acquired entity, and the
relationship of the customer-related asset with the acquired entity’s other assets and liabilities. Such
considerations facilitate a better understanding of a market participant’s view of the asset.
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3.3.2 The existing accounting literature does not explicitly address the economic aspects of customer-
related or other non-financial assets. Rather, valuation specialists determine how the economics (cash
flows or profits) will be allocated among acquired assets including the customer-related assets. At a basic
level, the task is to assess the nature and importance of the customer-related asset relative to the other
assets of the subject business. In many cases, the importance of the customer-related assets relative to
other assets is fairly clear. In other cases, it is more difficult to assess the relative importance of different
assets. As an example, for purchase order customers the accounting literature requires recognition of an
asset (as purchase orders meet the contractual criteria). However, in certain circumstances it may be
reasonable to assume that the customer-related assets are not a significant value driver for the business and
their respective fair value presumably is less than the value of other assets. In any case, it is critically
important to make reasonable assumptions about how the cash flows are allocated among the different
assets of a business.
3.3.3 In assessing the relative importance of the various assets of a business, it may be useful to identify
the “primary asset(s).” While there are no references to primary assets in FASB literature (aside from ASC
360, which uses the term in a different manner), an SEC staff speech18 noted the importance of assessing
the characteristics of customers and referenced the concept of a primary asset. In the Working Group’s
view, a primary asset of a business is an asset that has significant importance to the business relative to
other assets and is a key business driver from an economic perspective (e.g., cash flows).
3.3.4 Depending upon the nature of the business, the primary asset(s) may be tangible assets such as real
or personal property; identifiable intangible assets such as customers, technology or brands; or other assets
or business attributes such as workforce, assemblage of assets, or other elements of goodwill. In addition,
it may also be possible for there to be no clear primary asset(s) in a business. Determination of the primary
asset(s) assists the valuation specialist in choosing the appropriate methods to use to measure the fair
value of the different assets of the business, including customer-related assets.
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3.3.5 It is important to observe that customer-related assets have characteristics that are different from
most other assets of a business. Customer-related assets can be viewed as the result of the business assets
18 Remarks made by SEC professional accounting fellow Joseph Ucuzoglu at the 2006 AICPA National Conference on Current
SEC and Public Company Accounting Oversight Board (PCAOB) Developments.
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used to create and sell a product or service. Most other assets are typically used to create and sell products
or services that are purchased by the customers. In other words, a company assembles fixed assets,
working capital, and other intangible assets to produce a product or provide a service. It is important to
assess why the customers are paying a company what may appear to be more than a fair return on the
assets deployed by the company to create and sell the product or service. This assessment is necessary
when considering the relative fair value of the various assets of a business.
3.3.6 When measuring the fair value of customer-related assets in the context of a business combination,
the valuation exercise is holistic in nature and must keep the relative contributions and values of all the
assets of the business in context. The intent of this section is to focus more closely on considerations that
affect the valuation of the customer-related assets; however, these considerations could also be applied to
other assets acquired in a business combination that do not have a readily observable market value. The
relative contribution of all the assets to the total cash flow or profit of the business needs to be understood
by the valuation specialist. There are a number of ways a valuation specialist can evaluate the relative cash
flow or profit allocation associated with the various assets. For example, some of the assets can be
benchmarked to observed royalty data. It may also be possible to view the business as one or more
businesses, which may allow the valuation specialist to analyze returns to different peer groups that own
different asset mixes. Peer company margin analyses may also provide relative indications of proper
return allocations for the assets. These considerations, along with the various qualitative characteristics
discussed below, will allow the valuation specialist to make a better informed decision regarding the
relative importance of each of the assets acquired to the overall business cash flows and profit.
3.3.7 The following are factors to be considered for the purpose of gaining a qualitative understanding of
the relative importance of the customer-related assets being valued and subsequently selecting appropriate
valuation methodologies. They are grouped into four categories: industry characteristics, business
characteristics, product/service characteristics, and customer-related asset characteristics.
a. Industry Characteristics:
i. Concentration of Firms – Industries can be classified along a continuum, with highly
fragmented providers at one end and highly concentrated providers at the other. At one
extreme (i.e., in a pure monopoly) customers have no choice but to buy products or
services from the sole provider. In the absence of choice of providers, it may be reasonable
to conclude customer-related assets have nominal value, or that the value of customer-
related assets is limited to a simple calculation of the cost to identify and contract with the
customers. In such a case, a different asset (e.g., an exclusive operating right or a unique
and protected technology with no meaningful substitutes) is giving rise to excess income in
the form of monopoly profits and such income should be recognized in those assets that
create the excess profit. At the other extreme (i.e., in a fragmented market), given the
ability to choose among multiple providers and all else being equal, customers that
repeatedly choose the entity may represent an asset of high relative importance compared
to other assets—these customers could have their needs equally met by many providers, yet
they choose the entity over the others.
ii. Buyer Power – Similar to the factor above, evidence of strong buyer power may indicate
the relative importance of customer assets. If customers have power, which is usually a
function of choice and/or low switching costs, a demonstrated ability by the subject
business to retain these customers suggests they are an important asset. If customers have
little power (e.g., less choice and/or high switching costs), the entity’s demonstrated ability
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to retain the customers may be due to a different asset. That said, it may be the nature of the
customer contracts that limit choice, which would suggest a higher value for customer-
related assets.
iii. Barriers to Entry – Industries with high barriers to entry may enjoy excess economic
profits. The source of the barriers to entry should be considered. For example, a unique
technology might not be easily replicated, which limits competition and customer choice.
This in turn limits customer-related asset value—the valuable asset is the technology.
b. Business Characteristics:
i.
Type of Business – As a simple starting place, the type of business may indicate whether
customer-related assets will have significant value. For example, a retail operation with
largely walk-in business may not have an identifiable customer base. However, a wireless
telecommunications business with mostly long-term contractual subscribers may have
significant customer-related assets.
ii. Relative Asset Class Spend – Consideration of relative investments (i.e., operating or
capital expenditures) made in different asset classes may indicate the relative importance of
those assets, including customer-related assets. For example, a company that spends
significantly on development of customer relationships or customer retention (selling,
marketing, proposals, customer care, etc.) may have important and valuable customer-
related assets. If spending on technology and/or brands is comparable, the asset mix may be
well balanced. However, if spending on technology and/or brands is significantly more, the
customer-related assets might be less valuable.
iii.
iv.
Promotional Strategy – The promotional strategy of a business may indicate the importance
of customer-related assets. For example, if a company references existing customers in its
marketing collateral (e.g., case studies and testimonials), it likely believes those customers
are valuable assets that help generate sales to new customers.
Transaction Structure and Strategy – In instances where customer relationships are being
valued as part of a transaction, it is important to understand the reasons why the market
participant is making the business or asset acquisition and the underlying basis for the
pricing. For example, the valuation specialist needs to understand if a significant part of the
acquisition rationale is to acquire the existing customer relationships and their related
revenues and earnings, if the business purpose is to increase market share, and/or if the
business purpose is to increase the acquirer’s ability to cross-sell to new customers.
Understanding the strategic intent of the transaction may provide insight into the
importance of the customer-related assets.
c. Product/Service Characteristics:
i.
ii.
Product Differentiation – This is a consideration similar to buyer power and barriers to
entry. Highly differentiated products may limit customer choice, which reduces customer-
related asset value. At the other extreme, less differentiated products may indicate strong
relationships if customers choose one company over others. However, the value of such
relationships may be low because profits are low.
Switching Costs – This factor can be thought of as a barrier to exit for the customer. If
switching costs are high, customers may be captive. However, the source of the high
switching costs may lead to the most valuable asset(s). For example, if switching costs are
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high because of restrictive contract terms, customer contracts may be valuable. However, if
switching costs are high because of geographic proximity issues, the customer contract
might have less value.
iii. Life Cycle Stage – The life cycle of different products may indicate the relative importance
of one asset versus another. A leading-edge technology may indicate an important
technology-related asset but a less valuable customer-related asset due to customers having
limited choice if they want the leading-edge technology.
iv.
Protective Rights – All protective rights should be examined: patents, customer contracts,
registered brands, etc. The presence of protective rights may have implications on the fair
value of any particular asset.
d. Customer-Related Asset Characteristics:
i.
Purchase-Order Based vs. Long-Term Contract Based – The nature of customer contracts
can range from purchase-order based to long-term contract based. If purchase-order based,
buying patterns can be recurring or non-recurring. These distinctions may inform the
valuation specialist about, among other things, the relative importance of the customer-
related asset and attrition patterns for a customer model. If relationships are long-term
contract based, the terms of the contract(s) should be analyzed. These terms include the
typical length of a contract and the rights of each party with respect to renewal,
termination, price/volume adjustments, take or pay clauses, minimums, etc. This analysis
may impact choice of model, likelihood of a customer relationship subsequent to the
expiration of the contract term, attrition assumptions, and other valuation inputs.
ii. Attrition – Historical and expected attrition patterns and how these patterns may vary
according to possible customer relationship cohorts or groupings should also be discussed
with management. These discussions will inform the valuation specialist about an
appropriate economic life and the relative value of the customer assets to other assets. This
is a qualitative analysis used to assess the relative importance of customer-related assets at
the outset of an engagement. Quantitative analysis of customer attrition would also be
completed as part of the actual valuation, as discussed in more detail in Appendix A of this
Valuation Advisory.
iii. Depth of Knowledge – Customer relationships should be examined for depth of knowledge
possessed by the business about the customers. For example, walk-in customers at a
convenience store may not be identifiable nor do they meet the recognition criteria.
Conversely, purchase-order based customers in a business-to-business context may be
readily identifiable and recurring historical buying patterns may be observable, which
would suggest these customer relationships are recognizable for financial reporting
purposes and should be considered for valuation.
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4.0 VALUATION METHODOLOGIES
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4.1 Introduction
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4.1.1 When measuring fair value for financial reporting purposes, there are three generally accepted
approaches a valuation specialist should consider in the valuation of customer-related assets: the income
approach, the cost approach, and the market approach. A general overview of the three approaches (and
variations, where applicable) follows below.
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4.1.2 In the valuation process, methodology or model choice should reflect careful qualitative and
quantitative assessment of the asset and the availability of necessary data. Each of these approaches, as
well as the inputs used to value the customer-related assets, should be considered from the viewpoint of
market participants. The income approach is the most common approach used in the valuation of
customer-related assets; therefore, the application of the income approach is the primary focus of this
Valuation Advisory.
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4.2 Income Approach
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4.2.1 The income approach is used to estimate fair value based on the future cash flows that an asset can
be expected to generate over its economic life. The theory underlying this approach is that the valuation of
an investment in income-producing assets is directly related to the future cash flow generated by such
assets or to the cash flow indirectly saved through ownership of the asset. Cash flow represents the
recovery of the investment and the receipt of income produced by such an investment (a return on that
investment).
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4.2.2 According to ASC 820, the income approach uses “valuation techniques that convert future
amounts (for example, cash flows or income or expenses) to a single current (that is, discounted) amount.
The fair value measurement is determined on the basis of the value indicated by current market
expectations about those future amounts.”19 A similar definition is included in IFRS 13 (B10).
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4.2.3 The methods under the income approach that are commonly utilized to value customer-related
assets include the following:
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a. Multi-Period Excess Earnings Method – The Multi-Period Excess Earnings Method (MPEEM) is
an income approach methodology. It is a broadly used approach and may be employed when the
customer-related asset being valued is a primary asset or when a different asset is the primary asset
and can be appropriately valued using another valuation methodology. The MPEEM measures
economic benefits by calculating the cash flow attributable to an asset after deducting appropriate
returns for contributory assets used by the business in generating the customer-related asset’s
revenue and earnings (commonly referred to as “contributory asset charges” or CACs).
b. Distributor Method – The Distributor Method (also known as the Distributor Model) is a variation
of the MPEEM that may be appropriate when the nature of the relationship between an entity and
its customers is similar to that of a distribution company and its customers. Specifically, the
Distributor Method is appropriate when the customer-related activities and the value added for the
entity by those activities are similar to the value added by distributors. Where intangibles such as
19 Accounting Standards Codification™ 820-10-20.
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strong brands or unique, high-value technology are driving customer demand and customer
specific efforts are limited, the Distributor Method may be an appropriate means of valuing
customer-related intangibles. The application of the Distributor Method incorporates distributor-
based margins and CACs consistent with a distributor in the valuation of customer-related assets.
Using distributor inputs directly isolates the cash flow attributable to the customer-related assets,
similar to how the use of a royalty rate isolates cash flow associated with a particular asset.
c. With-and-Without Method – The With-and-Without Method (see the Premium Profits Method in
International Valuation Standard 210, Intangible Assets) estimates the value of customer-related
assets by quantifying the impact on cash flows under a scenario in which the customer-related
assets must be replaced (assuming all of the assets required to operate the business are in place—
except the customer-related assets—and have the same productive capacity). The projected
revenues, operating expenses, and cash flows are calculated in a “With” and “Without” scenario,
and the differential between the cash flows from the two scenarios serves as the basis for
estimating the fair value of the customer-related asset.
d. The Cost Savings Method – The Cost Savings Method is a form of the income approach that
directly measures an expected future benefit stream of an asset in terms of the future after-tax
costs, which are avoided (or reduced) as a result of owning the asset. Given that the Cost Savings
Method is based on a direct measure of future economic benefits that arise from having the asset in
place and assumes the subject asset exists at the date of the valuation, the Working Group believes
opportunity costs should not be included in this method. The Cost Savings Method may be
appropriate when the subject asset results in saving costs, avoiding expenditures, or improving
efficiency, etc.
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4.3 Cost Approach
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4.3.1 The cost approach uses the concept of replacement as an indicator of fair value. The premise of the
cost approach is that an investor would pay no more for an asset than the amount for which the utility of
the asset could be replaced.
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4.3.2 According to ASC 820, the cost approach is “a valuation technique that reflects the amount that
would be required currently to replace the service capacity of an asset (often referred to as current
replacement cost).”20A similar definition exists in IFRS 13 (B8).
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4.3.3 The SEC has indicated that in certain instances when using a replacement cost approach, it may
also be appropriate to include opportunity costs incurred.21 Opportunity costs represent foregone value
(measured as returns, profits, cash flows, or a similar metric) during the period that the recreation of the
asset has an impact on the business. In the view of the Working Group, the cost approach is best used in
circumstances where the customer-related asset can be replaced in a short period of time and is likely to
have relatively low opportunity costs or when total replacement costs are easily estimated. In instances
where it takes a long time to replace the customer-related asset and opportunity costs may be significant or
when replacement costs are not easily estimated, another valuation methodology may be more appropriate.
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4.4 Market Approach
20 Accounting Standards Codification™ 820-10-20.
21 Remarks made by SEC professional accounting fellow Sandie Kim at the 2007 AICPA National Conference on Current SEC
and PCAOB Developments.
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4.4.1 The market approach is used to estimate fair value based on market prices of comparable assets.
The valuation process is essentially that of comparison and correlation between the subject asset and other
similar assets. Characteristics of the subject and similar assets and conditions of sale for comparable assets
are analyzed and potentially adjusted to indicate a value of the subject asset. The level of activity in the
market in which the transaction is observed is a factor that should be considered in assessing the reliability
of such an indication.
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4.4.2 According to ASC 820, the market approach is “a valuation technique that uses prices and other
relevant information generated by market transactions involving identical or comparable (that is, similar)
assets, liabilities, or a group of assets and liabilities, such a business.”22 A similar reference is included in
IFRS 13 (B5).
4.4.3 The market approach is used for the valuation of assets when they are exchanged in separate
observable transactions. This makes the market approach very difficult to apply to customer-related assets
in most industries. However, there are certain types of customer-related assets that may be valued using
the market approach. For example, newspaper subscribers, pharmacy prescription data and lists, bank core
depositors, loan customers, credit card customers, etc., may be appropriately valued using the market
approach.
4.4.4 In our view, because transactions of customer-related assets typically are not observable (either
because they do not generally occur at all or because specific information relating to transactions that do
occur is generally not available), the Working Group believes that use of this approach will be rare.
Valuation specialists should attempt to use either the income and/or cost approach when market-based
indicators of value do not exist or are perceived to be unreliable.
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22 Accounting Standards Codification™ 820-10-20.
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5.0 APPLICATION OF THE INCOME APPROACH
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5.1 Introduction
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5.1.1 The income approach is used to estimate fair value based on the future cash flows that an asset can
be expected to generate over its economic life. The theory underlying this approach is that the valuation of
an investment in cash-generating assets is directly related to the future cash flows generated by such assets
or to the cash flow indirectly saved through ownership of the asset.
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5.1.2 Generally, the cash flows related to customer-related assets are generated by a group of assets
working together (i.e., the customer-related asset together with other assets of the business; for example,
working capital, property, plant, equipment, trademarks, and technology). The use of an income approach
involves the determination of the following, each of which, as well as the value of the customer-related
assets, should be considered from a market participant viewpoint:
a. The cash flows applicable to the asset being valued;
b. The economic life of the asset; and
c. An appropriate discount rate that reflects the risk of the projected cash flows.
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5.1.3 The following sections outline key assumptions used
methodologies.
in
the various
income approach
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5.2 Multi-Period Excess Earnings Method (MPEEM)23
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5.2.1 The MPEEM is a form of income approach where projected cash flows applicable to the asset being
valued are estimated based on prospective revenue and earnings, net of taxes and CACs for other assets
used in generating the revenue and earnings and other adjustments as applicable (e.g., deferred revenue
adjustment). Each of the major inputs to the MPEEM is described in more detail below. As indicated in
other sections of this Valuation Advisory, all inputs should be consistent with market participant
assumptions. Because the starting point is commonly the prospective financial information (PFI) prepared
by management, care must be taken to ensure this consistency as noted in ASC 820-10-35-54A and IFRS
13 (89). In the following section, inputs most likely to require a market participant adjustment are
highlighted.
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5.2.2 Prospective Financial Information – A financial forecast for the entity should be the starting point
for identifying the cash flows associated with customer-related assets. Adjustments to forecasts provided
by management may be necessary in order to ensure that the PFI used is consistent with market participant
assumptions, as defined by management per ASC 820.
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5.2.3 Market participant revenue and operating expense synergies are included in fair value
measurements of intangible assets and should be identified in the customer-related asset forecasts. They
should also be evaluated against observable market participant data as long as the synergies are related to
the identified intangible asset being valued and are assumed to be a component of the consideration
23 This Method, and some of its inputs, is discussed in more detail in the VFR Valuation Advisory #1. VFR Valuation Advisory
#1, titled The Identification of Contributory Assets and Calculation of Economic Rents and dated May 31, 2010, was created by
the first Working Group and addressed the topic of contributory assets and charges.
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exchanged in a hypothetical purchase of the asset by a market participant. Buyer-specific synergies are
excluded from fair value measurements and should be identified and excluded from customer-related asset
forecasts.
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5.2.4 Customer Revenue – The MPEEM begins with an estimation of the revenues associated with
customers present at the measurement date and should not include revenue attributable to future customer
relationships. Revenues may be based on the overall forecast or may be segmented in order to give
consideration to multiple groups of non-homogeneous customers. Revenues for each customer group are
projected over their estimated economic life based on expected growth and attrition (or probability of
loss). The following inputs/factors should be considered when assessing customer revenue (customer
revenue attrition is discussed separately below).
a. Growth Rate for Existing Customers – Future revenue from existing customers should reflect price
and/or volume changes. Price changes represent variation in the price per unit, while volume
changes represent variation in the number of units sold. Price and volume projections should be
consistent with market participant expectations and based on observable data when possible.
b. Contractual Renewals and Revenue Patterns – When valuing customer contracts, it may be
appropriate to focus on revenue patterns associated with contract renewals as opposed to customer
attrition patterns. Discrete probabilities may be assigned to future contract renewals beyond the
term of the current contracts in place.
c. Revenue Synergies and Dis-Synergies – In some cases, market participants may believe that
revenue synergies or dis-synergies may be derived through an acquisition. Potential revenue
synergies (e.g., cross-selling opportunities, entrance into new market opportunities, etc.) or dis-
synergies (e.g., revenue lost from buyer/target product cannibalization, customers leaving post-
acquisition to avoid supplier overconcentration, etc.) should be reviewed to ensure that they are
consistent with market participant assumptions. If they are deemed to reflect market participant
assumptions, the revenues should be included (for synergies) or excluded (for dis-synergies) in the
customer-related asset valuation. The value associated with revenue synergies should reflect an
appropriate level of earnings, taxes, and contributory asset charges—which, in certain
circumstances, may differ from those of the customer revenues excluding synergies. For example,
if a buyer is projecting revenue synergies related to the sale of an acquired company’s products
through its own existing distribution network, the margin on this incremental revenue may differ
from the margin realized by the acquired company’s base business. Therefore, the synergistic
revenue may require contributory asset charges that are unique to this revenue stream (e.g.,
contributory asset charges for the buyer’s distribution network, workforce, etc.).
d. Economic Life – An asset’s economic life is defined in valuation literature as “the total period of
time over which an asset is expected to generate economic benefits” 24 for one or more users. Cash
flows are terminated when they or their present values become de minimis and have an immaterial
economic value. For order backlog-type assets, contract terms or other reliable estimates of order
fulfillment may be available to estimate the economic life. For contractual customer relationships,
the economic life is generally based on the contractual term plus any expected renewals, which
24 International Valuation Standards Council International Valuation Glossary, significantly based on the definition from the
International Glossary of Business Valuation Terms, which was adopted by the American Institute of Certified Public
Accountants, the American Society of Appraisers, the National Association of Certified Valuation Analysts, the Canadian
Institute of Chartered Business Valuators, and the Institute of Business Appraisers.
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should be consistent with the provisions of the contract and market participant assumptions. For a
discussion of the difference between economic life and useful life, see section 9.7 of this Valuation
Advisory.
5.2.5 For customer-related assets that are not subject to contracts with a defined length, the appropriate
economic life is less obvious and typically requires additional analysis. The economic life is a function of
the growth of existing customer revenue net of attrition. Frequently, the cash flows related to the projected
revenue approach, but never arrive at, zero. Such a result would imply an infinite projection period. As a
result, a question arises as to when the projections should be truncated in order to estimate the economic
life of the customer relationship. Several common methods used in practice are outlined below:
a. Method A: The number of periods in the valuation model should be extended for many years until
effectively 100% of the total present value of cash flows is identified. Cash flows are extended
until the inclusion of the last discrete projection year does not materially change the fair value
conclusion. An appropriate materiality threshold should be discussed with management before the
valuation specialist makes this determination. This method extends the forecast period many years
into the future, with no specified guideline for determination of the point at which cash flows
should be truncated.
b. Method B: Under this view, the valuation specialist determines when to truncate the cash flows.
Two approaches generally seen in practice include:
i. Method B1: The number of periods in the valuation model is extended for many years so
that effectively 100% of the cash flows are identified, similar to the approach used in
Method A. However, unlike Method A, the number of periods in the valuation model is
then truncated at the point where the vast majority of the present value of the total cash
flows is captured. Common thresholds used for the vast majority of the present value of the
total cash flows are 90%, 95%, or 99%. The truncation threshold chosen should be
reviewed in relationship to its total impact on the value conclusion.
ii. Method B2: The valuation model is extended until the present value of cash flows
occurring in the final year are immaterial to the overall value. As a result, cash flows can be
truncated at the point where the present value of cash flow generated in a given year is less
than a defined percentage of the cumulative cash flows for all years up to and including
that year. Common truncation points are where the present value of the last discrete year of
projected cash flows is adding 3%, 2%, or 1% to the present value of the total cash flows
captured up to that point. The truncation threshold chosen should be reviewed in
relationship to its total impact on the value conclusion.
5.2.6 The following example illustrates the use of methods B1 and B2 to truncate cash flows:
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Example 5.1: Cash Flow Truncation
Year
Present Value
of Cash Flows
Method B1:
Cumulative Percent
of Present Value
Captured
Method B2:
Incremental Percent
of Present Value
Captured
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30
65.5
64.2
57.5
50.0
42.7
32.3
24.4
18.5
14.0
10.6
8.0
6.1
4.6
3.5
2.6
2.0
1.5
1.1
0.9
0.7
0.5
0.4
0.3
0.2
0.2
0.1
0.1
0.1
0.1
0.0
15.9%
31.4%
45.4%
57.5%
67.8%
75.6%
81.6%
86.0%
89.4%
92.0%
93.9%
95.4%
96.5%
97.4%
98.0%
98.5%
98.9%
99.1%
99.3%
99.5%
99.6%
99.7%
99.8%
99.9%
99.9%
99.9%
100.0%
100.0%
100.0%
100.0%
15.9%
15.6%
13.9%
12.1%
10.3%
7.8%
5.9%
4.5%
3.4%
2.6%
1.9%
1.5%
1.1%
0.8%
0.6%
0.5%
0.4%
0.3%
0.2%
0.2%
0.1%
0.1%
0.1%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
Total
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a. Method B1 shown above is based on the cumulative percent of present value captured through
each year in the projection period, while Method B2 shown above is based on the incremental
percent of present value added by each additional year in the projection period.
b. In this example, the common truncation points of 90%, 95%, and 99% under Method B1 are
achieved in years 10, 12, and 18, respectively. In dollar figures, the example indicates that
approximately $379.8, $393.8, and $409.2 of the total cash flow of $412.6 is being captured
through years 10, 12, and 18, respectively. Stated another way, by truncating the projections in
years 10, 12, and 18, dollar values of $32.9, $18.8, and $3.4, respectively, would not be captured in
the concluded value.
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c. In this example, the common truncation points of 3%, 2%, and 1% under Method B2 are achieved
in years 10, 11, and 14, respectively. In dollar figures, the example indicates that an incremental
$10.6, $8.0, and $3.5 are being included in years 10, 11, and 14, respectively.
d. Although the present value of the cash flows in this example extend for 30 years, it may be
reasonable to truncate the cash flows by giving consideration to one or both of the methods
discussed above. When determining the appropriate truncation threshold, the impact to the final
valuation conclusion of the present value of cash flows beyond the truncation threshold should be
taken into consideration. In the above examples, the Working Group notes that certain truncation
points may be viewed as excluding an inappropriately high amount of cash flow from the
concluded value.
5.2.7 Customer Revenue Attrition – Attrition is the measurement of the rate of decay/loss of existing
customers and is utilized to help forecast the expected future cash flow resulting from the existing
customer relationships. Customer count and revenue are often used as a proxy for determining the pattern
of attrition. When determining future customer decay/loss patterns, there are two key considerations that a
valuation specialist must factor into the analysis. First, the valuation specialist needs to consider the types
and quality of data that may be available to make future attrition estimates. Second, the valuation
specialist needs to be able to apply various methodologies to determine the future attrition pattern using
the given data available.
5.2.8 Attrition can be measured by reviewing several data sources including: historical customer count
data for customers with similar characteristics; historical customer revenue data for customers with similar
characteristics; representative population revenue and/or customer count data; or dollar-weighted revenue.
Attrition rates generally are calculated based on an analysis of historical customer revenue or count data.
For customers with similar characteristics (e.g., size and profitability), determining an attrition pattern
using historical revenue or customer count data is the generally accepted and widely applied methodology
used to estimate customer attrition. In situations where the customer-related assets have different size,
profitability, or other significant characteristics, it is sometimes necessary to divide the customer-related
assets into smaller subsets to get a more closely comparable data set. Table 5.1 below outlines several of
the common attrition data sources outlined above and the advantages and disadvantages of using each.
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Table 5.1: Common Attrition Approaches
Source
Description
Historical Population Revenue
Revenue data for the customer
population being valued is
available, by customer, for a
historical period of time. The
revenue data is analyzed and
attrition is calculated using
revenue gains and losses from the
customer population studied.
Most Frequently Used
When…
Historical revenue data by
customer has been maintained by
the subject company.
Future net growth/attrition
expectations are expected to be
similar to historical population
characteristics.
Historical Population Customer
Count
(also referred to as Customer
Churn)
Customer count data for the
customer population is available
for a historical period of time.
Customer data is analyzed and
attrition is calculated using
customer additions and deletions
from the population studied.
Historical Population Subset
Revenue and Count
Comparable Customer Population
Revenue or Count
In the absence of sufficient data
related to the entire customer
population, historical revenue and
customer count data related to a
subset of the population is used to
estimate attrition for the entire
population.
Historical customer revenue and
count data is unavailable for the
population being valued; however,
comparable customer population
revenue and/or count data is
available.
Historical customer data has been
maintained by the subject
company.
Revenue per customer is
consistent across the population
and future revenue per customer
can be projected and will be
consistent for the population.
Population subset characteristics
are consistent with the
characteristics of the entire
population.
Historical revenue and customer
count data is not maintained by the
company; however, data is
available for a similar customer
population. Similar customer
population data typically comes
from previous acquisitions or
perhaps by an acquiring
company's own customer
population, assuming the
population characteristics are
similar.
Advantages
Disadvantages
Intuitive.
Can be an objective input if
complete data is available.
Closest proxy for measuring
expected changes in cash flow.
Intuitive.
Can be a reasonable proxy for
future customer attrition especially
if customers generate similar
revenue amounts.
Data may not reflect a full
business cycle and can be either
overly optimistic or pessimistic.
Highly dependent on quality of
data maintained by the subject
company.
Revenue attrition and revenue
growth may be combined in the
attrition metric derived from
historical data.
Past data may not be reflective of
future customer attrition (e.g., in a
consolidating industry).
Revenue attrition may differ
significantly from customer count
attrition.
Applications are limited to
instances when individual
customers within a population
have similar revenue amounts.
Data sets may be more
manageable and easier to analyze.
It may be difficult to determine if
the population subset reflects the
attrition characteristics of the
entire population.
Provides an alternative to quantify
attrition patterns in absence of a
good population data set.
Customer population comparability
may be challenged and needs to
be well supported.
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5.2.9 An attrition analysis is used to assist in projecting the expected cash flows relating to existing
customer-related assets. The following paragraphs discuss best practices to determine attrition patterns and
how to apply them to future revenues or customer count.
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The most commonly used approaches to conduct an attrition analysis are outlined below and examples are
provided in Appendix A:
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a. Geometric or Arithmetic Averages Using Historical Customer Population Revenue or Customer
Count – These methods typically use a geometric or arithmetic average of historical customer
population revenue or customer count loss to project future attrition. The historical data used for
these methods come from the same customer group or population being valued. In order to use this
method, quality historical data needs to be maintained by management for the same customer
relationship population being valued. These methods tend to be relatively easy and straightforward
mathematical calculations. A demonstration of this method is outlined in Appendix A, example
A.1.a.
b. Geometric or Arithmetic Averages Using Historical Customer Subset or Comparable Population
Revenue or Customer Count – This method uses similar techniques as outlined above to analyze
data. However, data may not be available for the entirety of the specific customer population being
valued and therefore a subset of the population data or comparable customer population data may
need to be collected. In the context of a business combination, source data for this method could be
previous acquisitions by an acquirer or the acquirer’s own customer population data, if similar. In
addition, data on customer lives from comparable company public filings or other source data may
be used to assist in this method.
c. Customer Attrition Estimates From Third-party Data Sources – This method uses third-party data
sources to estimate future attrition rates or patterns. Third-party data sources are not widely
available and this method is also limited by issues of comparability. However, it may be seen as a
reliable quantitative source when comparable population data is available.
d. Statistical Techniques – Statistical techniques study customer account retirement behavior over a
fixed historical period in order to estimate customer relationship life characteristics. One of the
most widely used statistical techniques is the retirement rate method. The retirement rate method
starts by gathering initiation and termination date information for both active and retired customers
within a population set. The observed historical retirement rates are calculated for individual
customer vintages using a time series analysis. These retirement rates are then combined to
construct an observed survivor curve for the customer population. Once the observed survivor
curve is calculated, it may be compared to survivor curve models such as Iowa, Weibull, or similar
models to smooth the observed retirement pattern and extend the survivor curve. Typically, a least
squares regression technique is used to compare the observed curve to the survivor curve models.
Using this technique allows the valuation specialist to compare the observed curve to model
survivor curves and determine which model best minimizes the squared differences. These
statistical methods are widely accepted and the valuation specialist can best fit the observed curve
to model expected future decay/loss patterns. These methods require good quality historical data
on the customer population in order to conduct the analysis. A demonstration of this method is
outlined in Appendix A, example A.2.
e. Management Estimates – Often, and especially for early-stage companies, revenue and customer
count data for the subject company or from other industry sources is difficult to collect or does not
exist. In these cases, management may estimate future attrition patterns. These estimates may be
based on factors such as the useful life of other assets (e.g., technology), macro-industry trends,
etc. The advantage to this method is that these estimates are based on management’s educated
estimate and reflect their knowledge and experience. However, these estimates lack objective and
verifiable supporting evidence. Even when management estimates are used, the valuation specialist
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should make every attempt to document the rationale for these estimates. A demonstration of this
method is outlined in Appendix A, example A.3.
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5.2.10 Although the Working Group believes that the quality of data should not always be the primary
driver of method selection, a reasonable hierarchy of method quality may be as follows (most preferred to
least preferred):
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a. Actual historical revenue and customer count attrition data from the same customer group or
population being valued is used to determine future attrition trends. This may take the form of
geometric or arithmetic calculations or more sophisticated statistical techniques.
b. Actual historical revenue and customer count attrition data from a subset of the customer group or
population being valued is used to determine future attrition trends. This may take the form of
geometric or arithmetic calculations or more sophisticated statistical techniques.
c. If the above is not available, the historical attrition experienced by the acquiring company for a
comparable customer group to the population being valued (either from internally-generated
customers or from similar customers previously acquired).
d. If the above is not available, attrition derived from observed industry or other appropriate third-
party data sources.
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e. If the above is not available, attrition estimates derived through discussions with management.
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5.2.11 While the above methods of estimating attrition are useful, there are a number of circumstances in
which an analysis of historical attrition may be inadequate when projecting future attrition. In all cases,
factors that market participants may deem to affect future attrition patterns should be considered in
addition to historical attrition data when estimating future revenue attributable to customer-related assets.
Examples of potential factors are outlined below:
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a. Arbitrary or Random Customer Purchases – Customers may make purchases in a non-predictable
or seemingly arbitrary manner. In these cases, the guiding principle still remains to estimate the
cash flow that is attributable to current customers. As such, the analysis should focus on
determining a normalized or longer-term expected pattern. It may be that customer purchases are
random month-over-month or even year-over-year but exhibit an even longer-term trend, possibly
based on economic cycles. In some cases, an analysis of aggregate revenue from a group of
customers may be appropriate if the buying patterns are uncorrelated and an increase in purchases
by one customer is offset by an unrelated decline in purchases by another customer. Even if
purchase levels are considered random, it may be expected that customers would leave over time.
A demonstration of the analysis of irregular attrition patterns is outlined in Appendix A, example
A.4.
b. Small Number of Customers – If a small number of historically stable customers account for a
significant portion of revenue, historical attrition may understate the true risk of customer loss. In
this case, it may be possible to estimate the probability of each customer renewing their purchases
using specific customer and contract characteristics. Or, an aggregate customer analysis that views
the attrition rate as more of a probability adjustment may be more appropriate.
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c. No Observed Historical Attrition – Sometimes, customers or certain groups of customers have
historically exhibited little or no actual revenue or customer count attrition, or possibly even
revenue or customer growth. This may occur in industries where each customer is large and the
number of customers is small. This pattern may be expected to persist going forward, but it could
also be the result of a period of unsustainable growth, a change in customer characteristics, or
simply an entity having a very limited number of customers. If the pattern is expected to persist as
observed in the past, historical attrition may be used to project future cash flows. However, in most
cases it is likely this pattern would no longer hold and normal attrition would occur at some point
in the future. Other methods would need to be explored, including an analysis of an alternative
period of time, further customer sampling, or an analysis of economic or other external factors.
Detailed guidance from management may be required.
d. Customer Retention is Related to Other Assets – Customer retention may be driven by products,
technology, logistics, pricing, or other assets and elements of a business (identifiable or not). If the
life of the customer is constrained by an asset with a limited life, this factor should be incorporated
into the valuation of the customer-related asset. However, if customer attrition is calculated to be
low or even zero due to the presence of another asset in the business, a question arises as to
whether future cash flows should be considered attributable to customers. For example, the
economic life of a customer may be closely correlated to the lifespan of a technology asset. If the
technology becomes obsolete, the customer attrition pattern may be significantly different than
historical experience would indicate. During the transition between technologies, customers may
effectively make another purchasing decision that will be based on how the new technology meets
their needs.
5.2.12 For some types of businesses (those providing services to customers at a specific location, for
instance), attrition can be bifurcated into migration churn and loss churn. Migration churn is typically
applicable in situations where customers are identified by location or address and occurs when a customer
changes location and must stop and re-start service (for example, a cable customer moves and disconnects
service but re-subscribes from a new location). Loss churn refers to the total loss of a customer. The
Working Group believes that the decision as to whether a customer relationship is severed upon the
migration of a customer is a subjective one and should be discussed with management. Factors to consider
in making this determination include:
a. The opportunity of the customer to change providers during the move and the ease of doing so;
b. The length of the period between stopping and re-starting the service; and
c. Whether the migration is seamless or whether a material selling effort is required to retain the
customer.
5.2.13 Total business revenue is always derived from two sources: customers that existed at the
measurement date and customers added subsequently. Implicit in this, a valuation specialist could also
determine attrition of revenues from customers that existed at the measurement date by studying what
portion of total forecasted revenue is assumed to be derived from customers who were added
subsequently. The reasonableness of attrition assumptions should be assessed in the context of the overall
business revenue projection. This can be accomplished by using the existing customer revenue projection
and the total customer revenue projection to imply other assumptions that must be made regarding new
customers. For example, what is the implied new market share (i.e., share captured) of potential new
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customers in each period? What is the implied incremental market share captured each year? The answers
to these questions should be assessed for reasonableness.
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5.2.14 When estimating revenue and attrition, care should be taken when applying an attrition rate to
partial periods. Example A.5 provides an illustration of how to incorporate a partial period into an attrition
calculation to determine the appropriate revenue.
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5.2.15 After the revenue projection is prepared, the next step in the MPEEM is to estimate the operating
margin expected to be earned by the customers being valued.
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5.2.16 Expected Profitability/Earnings – The forecast associated with existing customers should only
capture the profit and cash flows related to the customer-related assets being valued. The initial basis for
estimating the expected profitability of existing customers should be the PFI. If the PFI includes expenses
that are unrelated to the customer relationships being valued, it should be adjusted to exclude these
expenses. Examples include (a) the portion of sales and marketing expense associated with the addition of
new customers, and (b) the portion of research and development (R&D) expense associated with new
products that will only be purchased by new customers. In addition, for entities that have grown through
acquisition, valuation specialists should remove any historical amortization expense related to pre-existing
intangible assets that may or may not be accounted for through a contributory asset charge. Including the
contributory asset charge and the historical intangible amortization expense would “double count” the
proxy for return of the intangible assets (one of which may be the customer-related asset being valued).
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5.2.17 In circumstances where the buyer is projecting market participant revenue synergies or dis-
synergies as part of the transaction, the valuation specialist should be consistent when evaluating the
incremental profit or loss related to the synergies.
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5.2.18 When multiple customer groups are present and management does not track operating expenses
by customer group, the expenses should be allocated in an economically appropriate manner. Commonly
used allocation metrics include customer count, volume, revenue, and gross profit.
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5.2.19 Certain expense adjustments may also be necessary to be consistent with the CACs being applied.
When the assembled workforce CAC is applied such that it captures the initial value of the assembled
workforce as well as growth in the workforce over time, the MPEEM should exclude operating expenses
related to the growth of the workforce to avoid double counting (see the VFR Valuation Advisory #1 for
further discussion and examples of this adjustment). It is noted, however, that future operating expenses
should include costs related to maintaining the assembled workforce that existed on the measurement date.
While this adjustment is not commonly made in practice, it may be appropriate for high-growth entities
where a significant cost of work force expansion may be included in the forecast. These additional
expenses related to work force expansion should be excluded from the customer relationship model. This
type of expense adjustment may be appropriate for other similar types of expenses.
5.2.20 Certain CACs are often applied in the form of a royalty rate (e.g., for trademarks, technology, or
other intellectual property). The expenses being applied should be consistent with the assumptions of the
selected royalty rate. A royalty rate should be analyzed to determine whether it compensates the licensor
for all functions (ownership rights and responsibilities) associated with the asset. Such an analysis would
include consideration of expenses recognized by the licensee versus expenses otherwise considered to be
the responsibility of the licensor. A royalty rate that is “gross” would consider all functions associated
with ownership of a licensed asset to reside with the licensor (and therefore it is likely that R&D expenses
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should be excluded from the forecast) while a royalty rate that is “net” would consider some or all
functions associated with the licensed asset to reside with the licensee (and therefore it may be appropriate
to include some or all of the R&D expenses in the forecast).
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5.2.21 Taxes – The tax rate used should reflect the tax implications from a market participant
perspective. The tax rate should not include entity-specific considerations (e.g., net operating losses or
NOLs, tax credits, etc.). While these tax attributes contribute to the value of the entity, they do not affect
the value of the customer relationships. A common starting point is the statutory tax rate, which is the rate
the company pays on its income prior to any adjustments for NOLs, tax credits, or other similar items.
This generally includes both a federal and state component in the US. For non-US companies or
companies that are taxed in multiple jurisdictions, an appropriate tax rate should be determined giving
consideration to the various tax jurisdictions in which the company operates.
5.2.22 Contributory Asset Charges – The application of the MPEEM includes the estimation of CACs
(also known as capital charges). A CAC represents the return on investment (ROI) an owner of the asset
would require. The ROI is comprised of a pure investment return (commonly referred to as return on) and,
in cases where the contributory asset deteriorates in value over time, a recoupment of the original
investment amount (commonly referred to as return of). The distinguishing characteristic of a contributory
asset is that it is not the subject income-generating asset itself; rather, it is an asset that is required to
support the subject income-generating asset. The CAC represents the charge that is required to
compensate for an investment in a contributory asset. In other words, it is a means of allocating a portion
of the subject entity’s expected cash flow to each of the contributory assets that support that cash flow,
giving consideration to rates of return required by market participants investing in such assets. By
including CACs in the valuation of the subject asset, the cash flow related to the subject asset can be
isolated and discounted at an appropriate rate of return to estimate fair value. Similar to the revenue and
earnings, care must be taken to ensure that the CACs are consistent with the market participant synergy-
adjusted PFI. This may include CACs on a market participant buyer’s assets utilized in generating the
projected market participant synergies. Conceptually, the adjustment of earnings for CACs should result in
an estimation of the projected cash flows attributable to the subject customer relationships. The issue of
preferred methods for determining appropriate CACs for use in the MPEEM is the focus of the VFR
Valuation Advisory #1. Please reference this document for a detailed discussion of this MPEEM
component.
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5.2.23 Discount Rate – When valuing customer-related assets using the MPEEM, the discount rate
chosen should reflect the risk profile of the customer-related assets from a market participant perspective.
The estimated weighted average cost of capital (WACC), cost of equity capital, and the internal rate of
return (IRR) are reference points to determine the discount rate of a customer relationship asset.
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5.2.24 The WACC is based on an analysis of current market rates of return in the subject industry and
represents the return on the investment in the subject entity required by market participants, including
both debt and equity investments. The WACC represents the required returns, from a market participant
perspective, on interest-bearing debt and equity capital weighted in proportion to their estimated
percentages in an observed or selected industry capital structure. The required return on equity capital for
an entity is commonly estimated using the capital asset pricing model (CAPM). However, there are other
methods that can potentially be utilized to calculate required equity returns, such as the Fama-French
three-factor model and the buildup method. Regardless of the method used, the WACC should include risk
elements that a market participant would consider when evaluating the subject company or subject assets
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and liabilities. Judgment must be used to ensure the discount rate reflects the asset-specific risk elements
or characteristics of the customer relationship.
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5.2.25 An IRR typically is calculated in a business combination and represents the discount rate, which
equates the present value of the PFI to the purchase consideration in a market transaction.25 The WACC
and the IRR should be compared and reviewed for reasonableness. An IRR that is significantly different
from the WACC may warrant a reassessment of both the PFI and the WACC calculation to determine if
market participant assumptions are being consistently applied or if adjustments need to be made in either
the PFI or WACC. While the purchase consideration is most often the best indication of fair value, the
valuation specialist needs to be alert for circumstances when this is not the case and there is evidence of,
for example, buyer-specific synergies, overpayment, or a bargain purchase.
5.2.26 The VFR Valuation Advisory #1 notes that “typically intangible assets necessitate a higher rate of
return than the WACC, due to the riskier and less liquid nature of intangible assets relative to working
capital and fixed assets…Circumstances can arise where the required return on an intangible asset is at or
below the WACC, depending on the relative asset mix in the entity and the specific nature of the
intangible assets.”26 In deriving an appropriate discount rate for a specific intangible asset, it may be
useful to first calculate the average return to intangible assets and goodwill in aggregate. This approach
still relies on the WACC or IRR but provides additional insight into the risk profile of the goodwill and
intangible assets as a group. Individual intangible asset discount rates can then be determined. Using the
WACC, cost of equity capital, IRR, or the average intangible asset and goodwill discount rate as a starting
point, a number of customer-related risk issues should be analyzed when determining the appropriate
discount rate for customer-related assets relative to these benchmarks, including:
a. Risk profile of the customer-related asset cash flow (i.e., more or less risky than the overall
company cash flow, more or less risky than other fixed/intangible assets);
b. Source of future business growth (established customer relationships versus new customers);
c. If attrition or probability of loss is built into the valuation model then it should not also be
accounted for in the discount rate;
d. Presence of significant switching costs;
e. Nature of relationships (presence or lack of a long term contract, dependence on a very small
number of customers, etc.);
f. If a contract is present, length of the contract, strength/enforceability of the contract, and likelihood
of renewal;
g. Reasons customers are retained; and
h. Stability/volatility of individual relationships and the revenue derived from those relationships.
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5.2.27 The above is not intended to be an exhaustive list. Further, while certain factors may lead to
increased or decreased risk (and therefore higher or lower discount rates), these factors should not be
viewed from a mechanical checklist or build-up perspective. Rather, these factors should assist the
25 “Purchase consideration” as used in this document refers to the consideration transferred (including contingent consideration)
plus the fair value of debt assumed.
26 The Appraisal Foundation, VFR Valuation Advisory #1 - Best Practices for Valuations in Financial Reporting: Intangible
Asset Working Group – Contributory Assets, The Identification of Contributory Assets and Calculation of Economic Rents
(Washington, DC: The Appraisal Foundation, 2010), 25.
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valuation specialist in choosing an appropriate discount rate by enabling a more complete understanding
of the valuation.
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5.2.28 Once the fair value of the assets and liabilities has been estimated, an analysis is performed to
evaluate whether the rates of return (i.e., discount rates) used to estimate the fair values of the individual
assets that were valued using an income approach and the implied return on goodwill are reasonable in the
context of the IRR and the WACC. This analysis is known as the weighted average return on assets
(WARA). The WARA is calculated as the sum of the required rates of return for normal working capital,
fixed assets, and intangible assets, weighted by each asset's proportionate share of the total value of the
entity (where “total value of the entity” means the combined value of debt and equity investment required
in the subject entity). When calculating the WARA, it may be appropriate to make certain adjustments to
ensure consistency in the tax assumptions used in the entity value and asset values.
5.2.29 The returns indicated by the three analyses (IRR, WACC, and WARA) should be reviewed for
reasonableness and any material differences should result in additional analysis. The additional analysis
may include material revisions to the selected discount rates and the fair values that were originally
estimated or revisions to the PFI used in the analysis. If the PFI is determined to reflect market participant
assumptions, buyer-specific synergies are not included, and the WACC and IRR still do not reconcile, it
may indicate overpayment or underpayment for the acquired entity. There is additional discussion
regarding the WARA analysis and the estimation of asset discount rates in the VFR Valuation Advisory
#1.
5.2.30 Tax Amortization Benefit – A Tax Amortization Benefit (TAB) reflects the present value of tax
savings relating to the amortization of the intangible asset over its tax life. The TAB is included in the
value conclusion, whether the actual or hypothetical transaction is taxable or non-taxable, for all
intangible assets that are valued using an income-based technique (including the MPEEM). There may be
instances (e.g., in certain countries where a TAB is unavailable under current tax law or in certain
instances when the market participant for an asset is a non-profit) where the addition of a TAB may not be
warranted. In instances such as those, the valuation specialist may want to consider specific advice from a
tax specialist.
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5.2.31 Accounting guidance in US GAAP (such as ASC 740, Income Taxes) requires that fair value
should not be net of any deferred tax liability or asset. It is generally believed that the fair value of an asset
should not differ because the tax structure of a transaction differed. Generally accepted valuation
methodology follows this guidance. The inputs to the TAB calculation include an appropriate discount
rate, the tax rate used in the model, and the number of years for which the tax deduction is effective.
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5.2.32 The Working Group notes that there is some discussion in the valuation profession regarding what
the appropriate discount rate should be for a TAB calculation. The discount rate used should be aligned
with the risk associated with the TAB itself. Many valuation specialists argue that the risk of the TAB is
closely aligned with the risk of the underlying asset that generates the TAB. Others argue that the risk of
the TAB is more closely aligned with the risk of the profit of a market participant that would realize the
TAB (i.e., a market participant WACC). For the examples in this Valuation Advisory, the Working Group
has used a discount rate equal to the rate used to value the intangible asset itself. However, this should not
be viewed as an endorsement by the Working Group of this method versus the other.
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5.2.33 In the US, there is a 15-year statutory life for most intangible assets. In other jurisdictions around
the world, there are a variety of conventions ranging from a statutory life to the estimated useful life. In
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some countries, the amortization of intangible assets for tax purposes is not permitted. The valuation
specialist should be aware of tax regulations and tax jurisdictions around the world and whether those
factors will impact the use of the TAB.
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5.2.34 The following example outlines how to calculate a TAB (assuming US tax law):
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Example 5.2: TAB Calculation
Assumptions
Present Value of Asset Cash Flows (PVCF)
Tax Amortization Period (years)
Tax Rate (t)
Discount Rate
100.0
15.0
40.0%
12.5%
Year
Period
Midpoint of
Period
Present Value
Factor
1 / Period
Present Value of
Amortization
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
0.5
1.5
2.5
3.5
4.5
5.5
6.5
7.5
8.5
9.5
10.5
11.5
12.5
13.5
14.5
0.9428
0.8381
0.7449
0.6622
0.5886
0.5232
0.4651
0.4134
0.3675
0.3266
0.2903
0.2581
0.2294
0.2039
0.1813
0.067
0.067
0.067
0.067
0.067
0.067
0.067
0.067
0.067
0.067
0.067
0.067
0.067
0.067
0.067
Present Value of the Annuity (PVA)
Tax Amortization Benefit (TAB) (1)
0.0629
0.0559
0.0497
0.0441
0.0392
0.0349
0.0310
0.0276
0.0245
0.0218
0.0194
0.0172
0.0153
0.0136
0.0121
0.4690
23.09
(1) Calculated as: TAB = PVCF x [ 1 / (1 - PVA * t) - 1 ]
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5.2.35 The value of the TAB can also be calculated using the following equation, with “PV” meaning
present value:
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TAB = PV of Cash Flows Excluding TAB * (n / (n - (Annuity Factor * Mid-Year Convention
Adjustment Factor * t)) - 1), where:
Annuity Factor = (1 / r) - ((1 / r) / (1 + r)^n) = PV(r, n, -1)
Mid-Year Convention Adjustment Factor = (1 + r)^0.5
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Where:
n = Straight Line Annual Tax Amortization Period in Years
t = Tax Rate
r = Discount Rate
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Applied to the example above, the TAB equation would be:
TAB = 100 * (15 / (15 - (PV(0.125,15,-1) * (1 + 0.125)^0.5 * 0.4)) - 1) = 23.09
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5.2.36 For specific examples of the application of the MPEEM, see Appendix B, Examples B.2 and B.3.
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5.3 Distributor Method
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5.3.1 The Distributor Method, a variant of the MPEEM, relies upon market-based distributor data or
other appropriate market inputs to value customer relationships. It may also be viewed as a profit split
method, in which function-specific profit is allocated to the identified assets. The underlying theory is that
a business is composed of various functional components (such as manufacturing, distribution, and
intellectual property) and that, if available, market-based data may be used to reasonably isolate the
revenue, earnings, and cash flow related to these functional areas. Using distributor inputs assists with
isolating cash flow attributable to the customer-related assets. A benefit of using the Distributor Method is
that it uses market-based data to support the selection of profitability and other inputs related to customer-
related activities (similar to the selection of a royalty rate in the relief from royalty method), thereby
allowing the potential use of the MPEEM to value other assets of the business if appropriate.
5.3.2 The Distributor Method may be applied to many different industries, such as a wide range of
manufacturing, technology, and branded consumer products industries, among others. For example, in the
branded consumer products industry, customer relationships generally have a supporting role and in many
cases are extremely stable due to end consumer demand for the company’s products. Distributor inputs
may serve as a reasonable proxy for the inputs used to value customer relationships because the customer
relationships of manufacturing companies in the consumer products industry may be similar to the
relationships that distributors have with their customers. The relationships are generally transactional in
nature with minimal switching costs.
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5.3.3 Distributors are typically low value added providers with limited intangibles and low profit
margins. As such, the profit margins of a distributor would be expected to require fewer adjustments to
estimate the profit margin of low value added customer relationships as other intangible assets would have
limited impact on profit margins.
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5.3.4 Using distributor inputs is appealing when valuing certain customer relationships because it
disaggregates the cash flow that can be used to value customer assets based on a MPEEM. For example,
the cash flows related to product technology or brand are included in the distributor’s cost of goods sold
(i.e., product cost). Contributory charges for the use of the distributor’s assets (e.g., fixed assets, working
capital) would also apply. The use of this methodology gives the valuation specialist the option to use the
MPEEM to value another asset of the business (e.g., brand or technology) without the challenges caused
by multiple MPEEMs with circular cross-charges.
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5.3.5 Key inputs to the Distributor Method are described below. These inputs should be considered
from a market participant perspective.
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a. Comparable Companies – When applying the Distributor Method, the valuation specialist should
select a group of comparable distributors such that the nature of the relationship between the entity
and its customers is similar to that of the distribution comparables and their customers. Several
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types of distributors are typically observed in the marketplace. For example, distributors of
branded consumer products have limited margins and although they can distinguish themselves in
the marketplace through pricing and service, they have no ability to differentiate through the goods
they sell because typically other distributors are selling the exact same products. In contrast,
industrial distributors may be able to differentiate based on pricing and service as well as breadth
of inventory and the related ability to provide specialized products demanded by customers.
Finally, value added distributors/resellers may realize higher margins because they are providing
additional value in the form of services.
b. There may be additional situations where a selected group of companies provides an appropriate
proxy for the customer relationship function. An example would be an industry in which certain
companies have proprietary intellectual property (IP) and others do not. Those that do not have
proprietary IP would likely have lower margins and may, for purposes of valuing the customer-
related asset, provide reasonable inputs in the same manner as a distributor.
c. There may be additional situations where a selected group of companies provides an appropriate
proxy for the customer relationship function. An example would be an industry in which certain
companies have proprietary intellectual property (IP) and others do not. Those that do not have
proprietary IP would likely have lower margins and may, for purposes of valuing the customer-
related asset, provide reasonable inputs in the same manner as a distributor.
d. Revenue – Similar to the earlier description for the MPEEM, revenues projected in the Distributor
Method should reflect revenue expected from the acquired customers and should include expected
growth and attrition for the existing customer relationships, as described previously in Section 5.2
of this Valuation Advisory.
e. Expected Profitability/Earnings – When valuing customer-related assets under the Distributor
Method, margins used in the MPEEM should be consistent with those realized by distributors or
other businesses that share characteristics similar to the customer-related assets being valued. It is
important to understand the nature of the customer relationship so that an appropriate market-based
margin may be applied. For instance, if the relationships are purchase order-based (and similar to
those of a distributor), a distributor-type margin may be most appropriate. On the other hand, if the
company’s relationships with its customers are stronger and the company provides additional
services, a value added reseller margin may be more appropriate. The selection of the appropriate
margin requires an understanding of the nature of the company’s relationships with its customers
and involves judgment in determining the appropriate group of comparable companies and where
the subject relationships fit within that group.
f. Contributory Asset Charges – The CAC assumptions utilized in the application of the Distributor
Method should be consistent with the selection of the distributor margin and will include CACs for
assets utilized by a distributor. These assets typically include working capital, fixed assets,
corporate trademarks, and workforce at levels of investment consistent with a distributor. CACs
should not be included for assets not typically used by distributors, such as product trademarks,
technology, or manufacturing assets. CACs for these assets are not required because their value is
captured in the distributor’s cost of goods sold. The Working Group notes that, in aggregate, CACs
for a distributor are typically lower than the CACs for an integrated entity that also performs other
non-distribution activities. Please reference VFR Valuation Advisory #1 - Best Practices for
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
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Financial Reporting: Intangible Asset Working Group – Contributory Assets, The Identification of
Contributory Assets and Calculation of Economic Rents for a detailed discussion of CACs.
g. Discount Rate – The appropriate discount rate is generally calculated in a similar manner as
described above for the MPEEM, but with one potential additional consideration. In addition to the
market-based WACC or transaction-based IRR, it is also possible to support a discount rate for the
asset by calculating a WACC using distributor inputs. The distributor WACC calculation would
incorporate distributor betas and capital structures. As there are typically more publicly traded
companies in a given industry than publicly traded distributors in the same industry, the
information required for the distributor WACC calculation may be limited and the result should be
viewed as an additional or corroborating input rather than a primary input. Regardless of the
method used, the selected discount rate should appropriately match the risk characteristics of the
customer-related asset being valued and should be reasonable in the context of the WARA.
h. Other Considerations – Other considerations, such as treatment of revenue synergies and dis-
synergies, calculating the TAB, determining the economic life, etc., are consistent with the general
form of the MPEEM as described earlier.
5.3.6 Given generally accepted viewpoints on CACs including returns on components of goodwill
(especially in the context of a purchase price allocation), the Working Group believes that in most
situations the MPEEM should be used to value the primary asset of the business when the Distributor
Method is used to value the customer-related asset. If the MPEEM is not utilized together with the
Distributor Method, the valuation specialist should comment on and/or consider why this is appropriate.
Some examples of this are as follows:
a. The subject company is generating profit margins well in excess of what is expected by market
participants and above levels expected by reviewing reasonable returns on assets. This may exist
due to the following:
i. The company operates in a monopoly or similar environment thereby allowing significant,
non-normal returns on assets.
ii.
The company operates in a niche market, thereby achieving monopoly type returns.
Although the subject company is enjoying excess returns, others may not be willing to
enter the market as the same level of earnings may not be available to them as the second
or third entrant.
b. The subject company is operating at a loss, which may in part be due to non-normal expenses
(such as S&M or R&D) or allocations that suppress profitability. The valuation specialist believes
that there is value to the customer relationship assets that can be expressed through the Distributor
Method and conversely that there is value to the trademark or technology that is better expressed
through an approach other than the MPEEM.
c. There is strong evidence for inputs and alternative methods involving the identical assets in the
identical markets (e.g., a direct indication of value from a third-party transaction or a strong
royalty rate comparable data point).
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5.3.7 For a specific example of the application of the Distributor Method, see Appendix B, Example
B.1.
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
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5.4 With-and-Without Method
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5.4.1 The With-and-Without Method is an application of the income approach. This method estimates
the value of customer-related assets by quantifying the impact on cash flows under a scenario in which the
customer-related assets must be replaced and assuming all of the existing assets are in place except the
customer-related assets. As the time period required to re-create the customer-related asset increases, the
subjectivity of the required assumptions increases, which may limit the practicability of this approach.
Additionally, a significant re-creation period for the customer-related asset may create difficulties in
developing appropriate without scenario financial projections due to the impact of lost customers on other
business activities and assets.
5.4.2 This method requires two models to be used to value the customer-related asset. The “With
Scenario” (also referred to as the “Base Case”) captures the estimated cash flows from the business if all
of the existing assets were in place including the customer-related assets. In forecasting the cash flows of
the business with the customer-related assets in place (the With Scenario), the information used should be
consistent with or a component of the overall PFI for the business. The “Without Scenario” captures the
estimated cash flows from the business if all of the existing assets were in place except the customer-
related assets. The forecasted cash flow includes the impact of re-establishing the customer-related assets
(i.e., the cost to re-create the customer-related assets). The key adjustments made in developing the
Without Scenario are detailed below.
a. Revenue – The Without Scenario revenue projection involves estimating the sales levels generated
if the customer-related assets did not exist at the measurement date and had to be established with
the benefit of all other assets in place. To estimate the impact on revenue, factors including the
following should be considered:
i. Expected time to re-create customer-related assets and achieve revenue levels projected in
the With Scenario;
ii. Historical time it took to build the customer-related assets to current revenue levels;
iii.
Typical sales cycle;
iv. Length of time it takes to establish a new relationship with a prospect;
v.
Typical length of time between a sales proposal and a customer placing an order;
vi. Level of competition in the industry; and
vii.
Switching costs for the customer once they have accepted and started using the vendor’s
product. For example, if products are typically designed into a customer’s end product
specifications for an entire product cycle, it may take more time to establish the initial
customer relationship.
b. Cost of Goods Sold – A reduction in pricing might be required to gain market share, which might
drive gross profit margins lower. Further, high fixed cost of goods sold associated with
manufacturing/servicing the product may also drive margins lower. Thus, the valuation specialist
should develop a thorough understanding of the variable and fixed components of cost of goods
sold and how this may impact cost of goods sold during the re-creation period.
c. Operating Expenses/Replacement Costs – The PFI also should be adjusted to include the additional
direct and indirect costs that would be incurred to reestablish the customer-related assets.
Examples of replacement costs that may be required to establish relationships include:
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
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i. Additional selling costs associated with headcount, travel, etc., that would be required to
re-establish customer relationships. As a benchmark, it is helpful to understand what
portion of the subject business headcount and expenses support the generation of new
customers; and
ii. R&D and other engineering costs associated with customizing products to re-establish
customer relationships.
d. Additional Assets and Expenditures – The PFI should also consider the impact of any additional
assets or expenditures necessary above and beyond the assets existing at the date of value to
achieve the incremental cash flow associated with re-building the existing customer base.
e. Fixed versus Variable Costs – If the time period to rebuild the customer-related asset is relatively
short, one would expect a business would not change its expense structure and most of the
operating expenses would be fixed. If the time period to rebuild the customer-related asset is
longer, a business may modify its expense structure during the time necessary to re-create the
asset. These costs should be viewed from a market participant perspective.
f. Depreciation and Capital Expenditures – If the time period to rebuild the customer-related asset is
relatively short, one would expect a business would not change its level of capital investment since
projected capital outlays will be needed in a short time period once the customer-related asset is
fully re-created. If the time period to rebuild the customer-related asset is longer, a business may
modify its capital investment outlay during the time necessary to re-create the asset. This change in
capital investment would also affect the forecasted depreciation.
g. Working Capital – It is important to assess the impact of the rebuilding process on working capital
in the Without Scenario. Certain working capital components (such as accounts receivable and
payable) may scale quickly with changes in revenue. Other working capital components (such as
inventory) may be more fixed in nature due to the inability to sell off inventory to customers at the
onset of the Without Scenario.
h. Discount Rate – The Working Group believes that the discount rate used should be commensurate
with risks inherent in the projected cash flows and that the discount rates used in the With Scenario
and the Without Scenario should be the same, as differences in risk between the two scenarios
should be reflected in the undiscounted expected cash flows.
i. Economic Life – The total period of time over which an asset is expected to generate economic
benefits for one or more users. As such, the economic life is based on the attributes of the asset and
is estimated in a manner consistent with that used in an MPEEM as described earlier. The rebuild
period utilized in the without model is not indicative of economic life.
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5.4.3 The fair value of the customer-related asset is estimated as follows:
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a. Estimate the With Scenario fair value;
b. Develop the Without Scenario fair value;
c. Subtract the With Scenario fair value from the Without Scenario fair value; and
d. Add the TAB to conclude on the fair value for the customer-related asset.
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5.4.4 For a specific example of the application of the With-and-Without Method, see Appendix B,
Example B.4. Additionally, an example is included below.
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
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Example 5.3: With-and-Without Method
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Company A acquires Company B, a developer of software technology solutions. Company A acquired
Company B primarily for its technology and all other assets were thought to be easily replaceable.
Company B’s customer-related assets were valued using the With-and-Without Method. Based on a
review of Company B’s operations, it is believed that the customer-related assets could be replaced ratably
over a period of two years. The discount rate is 12.5% and the tax rate is 40%. The fair value of the
customer-related assets is estimated to be $463.0 million, as calculated below:
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
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With-and-Without Method (Without Scenario)
Year 0
Year 1
Year 2
Year 3
Year 4
Revenue Without Existing Customers
Less: Cost of Goods Sold
Gross Profit
$
750.0
(375.0)
375.0
$
1,000.0
(500.0)
500.0
$
1,200.0
(600.0)
600.0
$
1,350.0
(675.0)
675.0
$
1,450.0
(725.0)
725.0
(144.0)
(96.0)
-
360.0
(144.0)
216.0
60.0
(16.0)
(60.0)
200.0
$
1.5
0.8381
167.6
$
(162.0)
(108.0)
-
405.0
(162.0)
243.0
67.5
(12.0)
(67.5)
231.0
$
2.5
0.7449
172.1
$
See schedule on next page.
(174.0)
(116.0)
-
435.0
(174.0)
261.0
72.5
(8.0)
(72.5)
253.0
$
3.5
0.6622
167.5
$
(90.0)
(60.0)
-
225.0
(90.0)
135.0
(120.0)
(80.0)
-
300.0
(120.0)
180.0
50.0
(20.0)
(50.0)
160.0
$
0.5
0.9428
150.8
$
$
658.1
281.9
376.2
86.9
$
463.0
Less: Fixed Operating Expenses
Less: Variable Operating Expenses
Less: Incremental "Re-Creation" Expenses
Pre-tax Income
Less: Income Taxes (40.0%)
Net Income
Plus: Depreciation
Less: Changes in Working Capital
Less: CAPEX
Net Returns on Customer-related Assets
Midpoint
Present Value Factor
Present Value of Cash Flows
Sum of Present Value of Cash Flows (With Scenario)
Sum of Present Value of Cash Flows (Without Scenario)
Difference Between Scenarios
TAB
Fair Value
TAB Calculation:
Tax Life (n)
Tax Rate (t)
Discount Rate (r)
Annuity Factor
Mid-Year Adj Factor
TAB Factor
15
40.0%
12.5%
6.63
1.06
23.1%
Working Capital (WC) Calculation
= PV(r, n, -1)
= (1 + r) ^ 0.5
= (n / (n - (Annuity Factor * Mid-Year Adj Factor * t )) - 1)
Accounts Receivable (% of Rev.)
Inventory (% of COGS)
Accounts Payable (% of COGS)
7.5%
15.5%
14.5%
Total WC
WC / Revenue
WC Investment
Year 0
Year 1
Year 2
Year 3
Year 4
56.3
58.1
54.4
60.0
8.0%
75.0
77.5
72.5
80.0
8.0%
20.0
90.0
93.0
87.0
96.0
8.0%
16.0
101.3
104.6
97.9
108.0
8.0%
12.0
108.8
112.4
105.1
116.0
8.0%
8.0
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
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With-and-Without Method (Without Scenario)
Revenue Without Existing Customers
Less: Cost of Goods Sold
Gross Profit
Less: Fixed Operating Expenses
Less: Variable Operating Expenses
Less: Incremental "Re-Creation" Expenses
Pre-tax Income
Less: Income Taxes (40.0%)
Net Income
Plus: Depreciation
Less: Changes in Working Capital
Less: CAPEX
Net Returns on Customer-related Assets
Midpoint
Present Value Factor
Present Value of Cash Flows
Sum of Present Value of Cash Flows (Without Scenario)
Working Capital (WC) Calculation
Accounts Receivable (% of Rev.)
Inventory (Max of % of COGS & Starting Inv.)
Accounts Payable (% of COGS)
7.5%
15.5%
14.5%
Total WC
WC / Revenue
WC Investment
Year 0
Year 1
Year 2
Year 3
Year 4
$
750.0
(375.0)
375.0
$
200.0
(100.0)
100.0
$
800.0
(400.0)
400.0
$
1,350.0
(675.0)
675.0
$
1,450.0
(725.0)
725.0
(90.0)
(60.0)
-
225.0
(90.0)
135.0
(144.0)
(64.0)
(100.0)
92.0
(36.8)
55.2
60.0
(5.4)
(60.0)
49.8
$
1.5
0.8381
41.8
$
(162.0)
(108.0)
-
405.0
(162.0)
243.0
67.5
(44.0)
(67.5)
199.0
$
2.5
0.7449
148.2
$
(174.0)
(116.0)
-
435.0
(174.0)
261.0
72.5
(8.0)
(72.5)
253.0
$
3.5
0.6622
167.5
$
(120.0)
(16.0)
(100.0)
(136.0)
54.4
(81.6)
50.0
1.4
(50.0)
(80.2)
$
0.5
0.9428
(75.6)
$
$
281.9
Year 0
Year 1
Year 2
Year 3
Year 4
56.3
58.1
54.4
60.0
8.0%
15.0
58.1
14.5
58.6
29.3%
(1.4)
60.0
62.0
58.0
64.0
8.0%
5.4
101.3
104.6
97.9
108.0
8.0%
44.0
108.8
112.4
105.1
116.0
8.0%
8.0
Comments:
> Cost of Goods Sold (COGS) are a stable % of revenue. As such, their levels reflect revenue levels.
> Operating Expenses are assumed to be 20% of revenue in the With scenario, with 60% fixed (i.e., unchanged in the Without scenario) and
40% variable (i.e., a function of revenue levels in the Without scenario).
> The Incremental "Re-Creation" Expenses are those required to re-create the lost customer relationships.
> The Pre-tax Income reflects the offsetting effects of lower COGS and Operating Expenses in conjunction with higher
Re-Creation expenses.
> Working capital was projected by modeling accounts receivable (A/R), Inventory and accounts payable (A/P).
A/R is modeled as a constant percent of revenue, as such it declines when revenue declines.
Inventory is modeled as the greater of a % of COGS or starting Inventory. This reflects the expectation management would not
liquidate inventory they could sell after a modest period of time.
A/P is modeled as a constant percent of COGS, as such it declines when COGS declines.
The overall working capital source/use reflects the contrasting impacts of these items.
> Depreciation is the same as the With scenario as it is assumed there are no changes to the fixed asset base or capex.
> Capex is assumed to be the same as in the With scenario.
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5.5 Cost Savings Method
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5.5.1 The Cost Savings Method is a form of the income approach and is used to estimate the value of
customer-related assets based on costs/expenses avoided via ownership of the asset. In the context of an
operating entity, costs saved or avoided implicitly result in positive cash flows relating to the asset being
valued. In this way, it is a form of the income approach in that the conclusion is based on the present value
of future cash flows.
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5.5.2
It should be noted that there is a distinction between a Cost Savings Method as described herein
and a cost approach. The cost approach uses the concept of replacement as an indicator of fair value. The
premise of the cost approach is that an investor would pay no more for an asset than the amount for which
the utility of the asset could be replaced. Alternatively, the Cost Savings Method considers future or
forecasted cost savings through ownership of the asset.
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5.5.3 The following sections outline key assumptions used in the Cost Savings Method:
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a. Operating Expenses/Replacement Costs Avoided – Central to the valuation of an asset via this
method is an estimate of the hypothetical costs saved or expenses avoided due to the existence of
the customer-related asset, such as marketing expenses. As this method estimates costs saved
rather than revenue/costs incurred, the PFI that was developed in support of the transaction may
not directly provide the information required for this approach. However, an estimate may be
obtainable by comparing the PFI with a baseline projection that assumes the subject asset is absent.
b. Discount Rate – The Working Group believes that the discount rate used should be commensurate
with risks inherent in the projected cash flows. Using this method, the risk is associated with the
cost savings being achieved—e.g., the level of uncertainty surrounding the ability to achieve the
projected savings. In many cases, there is greater certainty about cost savings than revenue growth,
synergies, etc. As such, it may be appropriate for the discount rate to be less than the overall
company discount rate. However, the selection of the discount rate should reflect asset-specific
facts and circumstances.
c. Economic Life – The total period of time over which an asset is expected to generate economic
benefits for one or more users. As such, the economic life is based on the attributes of the asset and
is estimated in a manner consistent with that used in an MPEEM as described earlier.
d. Other Considerations – Other considerations include taxes and TAB and are consistent with the
general form of the MPEEM as described earlier.
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5.5.4 The fair value of the customer-related asset is estimated as follows:
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a. Estimate the cost savings for each projected year (or other period);
b. Adjust the sum of the cost savings and related profit for taxes;
c. Calculate the present value of the tax-affected cost savings; and
d. Add the TAB (based on the rules of the appropriate tax jurisdiction) to conclude the fair value for
the customer-related asset.
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5.5.5 An example of the application of the Cost Savings Method is below:
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Example 5.4: Cost Savings Method
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Company A acquires Company B, a manufacturer of consumables for the life sciences industry. Company
A acquired Company B primarily for its technology and all other assets were thought to be easily
largely wholesalers and manufacturer
replaceable. Company B’s customer-related assets are
representatives and were valued using the Cost Savings Method. Types of costs typically investigated
include avoided sales and marketing efforts, administration related to contracting, and other customer
acquisition-related expenses. Based on a review of Company B’s operations, it is believed that the
customer-related assets would generate economic benefits over a period of three years. The discount rate
is 12.5% and the tax rate is 40%. The fair value of the customer-related assets is estimated to be $77.5
million, as calculated below:
Cost Savings Method
Year 1
Year 2
Year 3
Annual Cost Savings
less: Income Taxes (40.0%)
After-Tax Cost Savings
$
60.0
(24.0)
36.0
$
40.0
(16.0)
24.0
$
20.0
(8.0)
12.0
Midpoint
Present Value Factor
Present Value of Cash Flows
0.5
0.9428
33.9
$
1.5
0.8381
20.1
$
2.5
0.7449
8.9
$
Sum of Present Value of Cash Flows
$
63.0
TAB
Fair Value
TAB Calculation:
Tax Life (n)
Tax Rate (t)
Discount Rate (r)
Annuity Factor
Mid-Year Adj Factor
TAB Factor
14.5
$
77.5
15
40.0%
12.5%
6.63
1.06
23.1% = (n / (n - (Annuity Factor * Mid-Year Adj Factor * t )) - 1)
= PV(r, n, -1)
= (1 + r) ^ 0.5
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APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
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6.0 APPLICATION OF THE COST APPROACH
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6.1
Introduction
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6.1.1 The cost approach uses the concept of replacement as an indicator of fair value. The premise of
the cost approach is that an investor would pay no more for an asset than the amount for which the utility
of the asset could be replaced.
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6.1.2 The application of the cost approach to value customer-related assets should consider the
following items:
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a. Direct costs (e.g., materials, labor, advertising, direct selling, etc.);
b. Indirect costs (e.g., general and administrative overhead);
c. Developer’s profit;
d. Opportunity costs; and
e. Obsolescence.
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6.1.3 The exclusion of indirect costs, developer’s profit, opportunity costs, and/or obsolescence may be
appropriate or inappropriate based on the specific facts and circumstances and appropriate valuation
methodology for the customer-related asset. The goal is to factor in all costs (direct, indirect, opportunity),
profit, and obsolescence that a market participant would consider in the valuation of the customer-related
asset.
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6.1.4 The Working Group believes the use of a cost approach to value customer-related assets may be
appropriate under certain fact patterns, including but not limited to the following:
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a. Customer relationships are not a primary asset of the business;
b. There are very few identified customer relationships;
c. There is limited or no sales history with existing customers;
d. There is limited or poor ability of management to forecast cash flows associated with existing
customers;
e. Management’s projection for existing customers suggests negative cash flow for the foreseeable
future, but nonetheless customers are viewed as having some value for other reasons;
f. The customer relationships do not convey significant rights or obligations—i.e., they are non-
exclusive; and
g. There are no significant barriers to entry or switching costs.
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6.1.5
The time period required to re-create the asset(s) (i.e., re-establish the customer relationship) is an
important consideration because a significant re-creation period may suggest that significant opportunity
costs exist. As it may be difficult to reliably estimate the magnitude of these opportunity costs, another
valuation technique, such as an income-based methodology, may be more appropriate.
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6.1.6 The following sections outline key assumptions used in the cost approach.
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6.2 Cost Approach
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6.2.1 Key inputs to the cost approach are described below:
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a. Direct Costs – Direct costs are expenses that can be directly linked to the creation of the existing
customer-related asset (e.g., materials, labor, or other asset-specific expense). Examples may
include sales staff time, company-specific marketing expenses, and customer entertainment.
Although direct costs should reflect the current costs that would be incurred to re-create customer-
related assets of equal utility, historical costs adjusted for inflation and/or other factors may be a
reasonable proxy.
b. Indirect Costs – Indirect costs are expenses that cannot be directly linked to the creation of a
specific existing customer-related asset (e.g., overhead). These costs are typically proportionally
allocated to all the customer-related assets. Examples include advertising campaign costs, public
relations expenses, broad media campaigns, and general printing costs. Indirect costs generally
also include general and administrative costs that were needed to oversee the creation of the
customer-related asset. Similar to direct costs, historical indirect costs should be stated on a current
cost basis (i.e., adjusted for inflation and/or other factors).
Direct and indirect costs should be inclusive of all costs associated with re-creating the customer
base at the date of valuation, including those costs that did not result in the successful addition of a
new customer. Inefficient efforts that are deemed to be irrelevant to the creation of the customer-
related asset should be excluded from the total cost build-up analysis. Examples of these costs may
include marketing expenditures related to unsuccessful sales channels, unsuccessful advertising
campaigns, etc. However, certain inefficiencies may be appropriate to include in a cost build-up
because they are inherent to the nature of acquiring customers and cannot be avoided even with
knowledge of the most productive marketing strategy. Examples of these costs may include
marketing costs directed toward the solicitation of a potential customer base that do not result in
successful customer additions (i.e., the “fully-loaded” cost per customer should include
unsuccessful solicitation attempts). Inclusion of only costs related to successfully developing an
existing customer relationship would lead to survivorship bias.
c. Developer’s Profit – Developer’s profit reflects the expected return on the investment (direct plus
indirect costs). Developer’s profit can be calculated based on a reasonable profit margin on the
development activities. This profit margin should include both the profit related to re-creation
efforts as well as a return on the assets employed in the efforts, and should reflect a market
participant perspective, using observable data, as available. Some estimated costs (e.g., costs paid
to an outside marketing or staffing firm) may already be inclusive of a developer’s profit.
The developer’s profit can be estimated by reviewing market participant margins on similar
activities. For instance, in deriving the developer’s profit on sales and marketing activities, a
reasonable metric may be to review margins of value added resellers or value added distributors.
The actual margins of the subject business may also be reflective of an appropriate margin.
d. Opportunity Costs – Opportunity costs represent foregone returns during the period that the re-
creation of the asset has an impact on the business. The premise behind this concept is that the
costs incurred to re-create the asset could have otherwise been invested, which would have resulted
in a return on a similar alternative investment. These costs are only present if the asset cannot be
utilized while being created. If opportunity costs are significant, application of the cost approach
might not be applicable.
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Opportunity costs may be calculated based on a reasonable rate of return on the expenditures
(including developer’s profit) while the asset is being created. For example, a reasonable rate of
return on the costs may be estimated similar to the rates of return estimated for customer-related
assets or other assets with a similar risk profile that would be valued using an income approach.
Although consistent with deriving market rates of return on other intangible assets, direct market
evidence typically is not available. A reasonable rate of return may be estimated by reviewing the
WACC, IRR and other similar metrics.
Opportunity costs can also be measured as lost profits or lost cash flows that occur as a result of
not having the asset in place. For example, revenue and related profit is not received from existing
customers while the customer-related asset is being re-created. The amount of profit lost is a
function of the amount of time required to re-create the asset and the impact that the asset has on
the business.
Although developer’s profit and opportunity costs both reflect an element of profit while the
customer asset is being constructed, they relate to different elements. From a practical perspective,
the developer’s profit is the level of profit required on capital employed in the creation of the
customer asset—i.e., the level of profit a third party would require if they were engaged in the
activities of creating the customer-related assets. In contrast, opportunity costs reflect the cash flow
foregone while the asset is being (re)created.
e. Obsolescence – In order to estimate the value of the customer-related assets, it is important to
consider various forms of obsolescence. Forms of obsolescence regularly considered in a cost
approach include physical deterioration, incurable functional and technological obsolescence, and
economic or external obsolescence. Due to the nature of customer-related assets, it is very unlikely
that physical deterioration or any form of incurable functional and technological obsolescence
would be present.
Economic obsolescence may be evident if the customer-related asset cannot generate a fair rate of
return over its remaining useful life based on the indication of value. Economic obsolescence can
be calculated as the present value of the economic shortfall measured as the difference between the
market participant forecasted return on the customer-related asset versus the owner’s required
return or demonstrated historical return. Alternatively, economic obsolescence can be calculated as
the present value of the economic shortfall measured as the difference between the forecasted
profit margin on the asset versus the owner’s required profit margin or demonstrated historical
margin on the asset. If it appears likely that economic obsolescence is present and significant, a
different valuation approach may be more appropriate.
Obsolescence due to age/life of the customer group being valued should only be done in limited
circumstances when the remaining life of the customer group is certain and known to be shorter
than the life that was expected for the customer group when initially created. In situations where
there is no clear relationship between an individual customer age and remaining life, an adjustment
to the aggregate customer group value is likely not appropriate.
f. Taxes – The costs estimated in this method are investment costs and not period costs, and therefore
the conclusion of the cost approach should not be tax affected. Nor should the conclusion be
adjusted for the TAB, as a pre-tax conclusion is consistent with an exit price that a market
participant would receive for the asset.
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
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6.2.2 An example of the application of the Cost Approach is below:
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Example 6.1: Cost Approach
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Company A acquires Company B, a manufacturer of branded consumer electronics. Company A acquired
Company B primarily for its brand and all other assets were thought to be easily replaceable. The purchase
consideration is $500 million (on a cash-free, debt-free basis). There are 1,000 customers. Company B’s
customer-related assets were valued using a cost approach. Based on a review of Company B’s operations,
the customer-related assets were created ratably over the past three years at an historic cost of $21 million
(direct costs of $15 million and indirect costs of $6 million).
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The historical costs are deemed to be representative of direct and indirect costs as of the date of value (i.e.,
they are current costs and do not need to be adjusted for inflation). The developer’s profit margin was
estimated based on market observations of profit margins earned by companies that perform similar
activities. Opportunity costs were calculated using a 12% rate of return and an average three-month lead
time between when the company first invests in a new customer and when the first purchase is made. This
reflects the profit that could otherwise be earned on an investment of commensurate risk during the three-
month period. There are various metrics that may be appropriate indications of required return for
purposes of calculating an opportunity cost; in this case, the WACC was viewed to be the most
appropriate as it reflects the overall risk-adjusted rate of return for the business. For the purposes of this
analysis, no obsolescence was determined to be present.
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The fair value of the customer-related assets is estimated to be $27.0 million, as calculated below:
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
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Cost Approach
Figures in Actuals
Direct & Indirect Costs
Direct Costs
Indirect Costs
Total Costs
Developer's Profit
Developer's Profit Margin
Developer's Profit
Opportunity Cost
# of Customers
Average Lead Time (years)
Required Return
Investment per Customer
Opportunity Cost per Customer
Total Opportunity Costs
% of Total
Value
55.5%
22.2%
$
15,000,000
6,000,000
21,000,000
20% (1)
5,250,000
19.4%
1,000
0.25
12%
26,250
787.5
787,500
(2)
(3)
(4)
2.9%
Total Cost
$
27,037,500
100.0%
(1) Calculated as: (Cost / (1 - Margin) * Margin), such that the margin earned on the
the cost is 20%. In this case, (Developer's Profit) / (Developer's Revenue consisting
of Costs plus Developer's Profit) = 20% margin.
(2) Calculated as: Total Costs (including Developer's Profit) / # of Customers
(3) Calculated as: Lead Time in Years * Required Return * Investment per Customer
(4) Calculated as: Opportunity Cost per Customer * # of Customers
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7.0 APPLICATION OF THE MARKET APPROACH
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7.1
Introduction
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7.1.1 The market approach is used to estimate fair value based on market prices of comparable assets.
The valuation process is essentially that of comparison and correlation between the subject asset and
similar assets. Characteristics and conditions of sale for comparable assets are analyzed and potentially
adjusted to indicate a value of the subject asset. For this approach to be reliable, customer-related assets
need to be exchanged in separate observable transactions.
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7.1.2 Because transactions of customer-related assets typically are not observable (either because they
do not generally occur at all or because specific information relating to transactions that do occur is
generally not available), the Working Group believes that use of this approach will be rare. Customer-
related assets are rarely transacted on a stand-alone basis; rather, they are typically acquired as part of a
business or group of assets. Therefore, information on market transactions of customer-related assets
generally is not available. A further limitation of the market approach is that if observable transactions
exist, the uniqueness of customer-related assets typically results in a lack of comparability with the subject
asset. However, this approach may be appropriate for certain types of customer lists such as prescription
files, subscriber lists, or frequent flyer/shopper lists when comparable transaction data exists and the buyer
is realizing full ownership rights to the asset versus simply a right to use the asset.
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7.2 Methodology
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7.2.1 Valuation Multiples – Similar to conducting a market approach for the purpose of valuing a
business or an equity interest in a business, a valuation multiple should be derived based on comparable
market transaction information. To the extent possible, the valuation multiple should be adjusted for
differences between the subject asset and the comparable assets. The related rights, obligations, and risk
profiles of the assets should also be considered when selecting an appropriate multiple. For example, a
customer list rental rate may not reflect the fair value of the customer list asset and adjustments may be
necessary to this market indication to arrive at its fair value that would be measured because the rental rate
may not include full ownership rights.
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7.2.2 Taxes – Market approach estimates of value are typically not adjusted for taxes, nor is a TAB
typically applied, as the price paid in a market transaction theoretically includes consideration of relevant
tax issues.
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7.2.3 An example of the application of the Market Approach is below:
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Example 7.1: Market Approach
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Company A acquires Company B, a regional pharmacy chain. Company B generates $1.0 million in
revenue per year and has 20,000 individual records. Market transactions indicate that pharmacy records
sell for $5 per record. The comparable pharmacy records are sufficiently similar to the records of
Company B that no adjustments to the observed valuation multiple are necessary. The value of the
customers is $100,000, as calculated below:
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20,000 records x $5 per record = $100,000
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
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8.0 VALUATION METHODOLOGY SELECTION
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8.1.1 The choice of an appropriate valuation methodology is critical to appropriately valuing customer-
related assets. As previously indicated, there are a number of methodologies that may be used. While
certain approaches are more commonly used and/or more broadly appropriate than others, all approaches
have positive and negative attributes. The facts and circumstances specific to the customer-related asset
being valued drive the selection of the appropriate valuation methodology.
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8.1.2 The valuation specialist should choose the methodology that is most appropriate and provides the
best indication of fair value. The following paragraphs provide information to help the valuation specialist
in this respect.
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a. MPEEM – The MPEEM is a broadly used method and may be employed when the customer-
related asset being valued is a primary asset or when a different asset is the primary asset and can
be appropriately valued using another valuation methodology. While the MPEEM is commonly
used because it incorporates PFI, there are a number of limitations as well as advantages to the
method. In instances where the elements of goodwill (such as assemblage value) of a business are
believed to have significant value, the propensity of the MPEEM to include goodwill elements in
the cash flows attributed to the customer-related assets becomes greater. This is commonly viewed
to be an acceptable limitation of the method; however, consideration of other valuation
methodologies may be appropriate in such circumstances. Additionally, use of the MPEEM
requires a number of assumptions and valuation judgments, including attrition analyses, lifing, and
the development of CACs, among others. In the Working Group’s view, the MPEEM is a useful
valuation method and its limitations are widely known and accepted and typically do not become
problematic so long as the analysis and underlying assumptions are well supported.
b. The Distributor Method – A benefit of using the Distributor Method is that it uses market-based
data to support the selection of profitability and other inputs related to customer-related activities
(similar to selection of a royalty rate in a relief-from-royalty model), thereby allowing the potential
use of the MPEEM to value other assets of the business if appropriate. In situations where market-
based information for distributor inputs is not available, an alternative method should be used.
Using distributor inputs is appealing when valuing certain customer-related assets because it
assists with isolating cash flow attributable to the customer-related assets; however, similar to the
MPEEM, these cash flows may also contain some elements of goodwill (although not to the same
magnitude as what may be captured through the MPEEM). This method is often appropriate when
customer-related assets are generally transactional in nature with minimal switching costs. In order
to effectively utilize this method, market data must be available for distributors that have
relationships with their customers that are similar to the relationships the subject entity has with its
customers. The use of this methodology gives the valuation specialist the option to use the
MPEEM to value another asset of the business (e.g., brand or technology) without the challenges
caused by multiple MPEEMs with circular cross-charges. In addition, similar to the MPEEM, this
method requires a significant number of assumptions and subjective judgments including selection
of distributor comparables and profit margin, CACs, attrition, and lifing, among others.
c. The With-and-Without Method – The With-and-Without Method is most likely to be considered
when the customer-related assets are not the primary asset. The method works best when
reasonable estimates can be made for the time and resources required to re-create the asset, which
is more likely to be the case when the re-creation period is short. However, in some cases, use of
the With-and-Without Method may produce asset cash flows that include elements of goodwill.
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
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Since the method presumes that the differential cash flow results in the customer value, one could
argue that the differential relates to other assets as well, including elements of goodwill. While the
method is logical in theory, it requires significant information and judgment in quantifying the
impact of the absence of the subject asset upon the cash flows of the business. For instance,
because the revenues of a business are sourced from its customers, there could be unanticipated
effects of not having customers in place (e.g., effects on future customer’s patronage and
longevity, the effect of having to win back customers from the competition, or the effect on future
investment). By using the With-and-Without Method to value customer-related assets, the
MPEEM may then be used to value another intangible asset (e.g., brand or technology).
d. The Cost Savings Method – The Cost Savings Method is a form of the income approach that
directly measures an expected future benefit stream of an asset in terms of the future after-tax
costs, which are avoided (or reduced) as a result of owning the asset. The Cost Savings Method is
not a re-creation analysis and is based on a direct measure of future economic benefits as opposed
to returns on past investments. The Cost Savings Method may be appropriate when the subject
asset results in saving costs, avoiding expenditures, or improving efficiency, etc. This method can
be used when the customer assets are not the primary asset and the costs saved can be estimated in
a straightforward manner. Unlike the With-and-Without Method, this approach allows for the
valuation specialist to directly forecast and measure incremental costs avoided due to the existence
of the asset versus the With-and-Without Method, which requires a forecast of all business
economics (revenues, operating expenses, etc.) under two scenarios.
Another issue to consider in relation to intangible assets in general is whether assemblage or going
concern value (both elements of goodwill) is embedded in the fair value of the asset and whether
or not it should attach to the asset. Many believe that use of an excess earnings method (including
the Distributor Method) or With-and-Without Method can lead to assemblage value or going
concern value being included in the residual cash flows because contributory charges or other
adjustments for those elements of goodwill are not generally determinable. Please see the VFR
Valuation Advisory #1 for further discussion related to this topic. The Working Group
acknowledges that it is possible that elements of goodwill may be included in asset values based
on the aforementioned valuation techniques; however, in most cases, it is difficult to measure how
much goodwill-related value may be included, and it is not generally accepted for a going
concern/goodwill CAC to be applied. The Working Group notes that this has commonly been
viewed as an acceptable limitation of the MPEEM that is outweighed by the method’s many
advantages.
e. The Cost Approach – The Working Group believes the use of a cost approach to value customer-
related assets may be appropriate under certain fact patterns as discussed in 6.1.4. Although
intuitive and objective, the Working Group believes that the cost approach suffers from a number
of limitations that restrict its usefulness. The cost approach may understate the fair value of
customer-related assets that are not easily replaceable or create an economic benefit that exceeds
the historical cost of developing the relationship. Additionally, due to survivorship bias and other
challenges in estimating the required inputs, the cost approach may not yield a reasonable value.
There are limited situations where other approaches may be considered too difficult, inappropriate,
or subjective, and in these cases a cost approach may provide a reasonable indication of fair value.
f. The Market Approach – The market approach is most appropriate for valuing customer-related
assets when there have been market transactions of comparable assets and the market data is
available. Although intuitive and objective, the Working Group believes that the market approach
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
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suffers from a number of limitations that restrict its usefulness. Customer-related assets are rarely
transacted on a standalone basis, and in most cases, any observable historical transactions will not
be comparable. However, in limited situations, such as when valuing certain types of customer
lists, historical transactions may exist and provide an objective indication of value.
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9.0 OTHER CONSIDERATIONS
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9.1
Introduction
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9.1.1 This section addresses other technical issues not previously covered in this document that,
depending on the facts and circumstances, may be relevant to the valuation of customer-related assets.
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9.2 Backlog
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9.2.1 Backlog typically represents a subset of the customer-related asset. As previously defined,
backlog represents products or services that have been contracted but have not been delivered or invoiced
as of the measurement date. The value of customer relationships is affected by revenues and earnings that
arise from future orders placed by existing customers. In estimating the fair value of customer
relationship assets, backlog (if significant and deemed to have different life, risk profile, and/or
profitability characteristics) may be valued separately.
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9.2.2 When backlog is valued separately from the customer relationship asset, care must be taken to
ensure that customer value is not double counted. When backlog is separately valued, its value should be
excluded from the value of the customer relationship asset. The valuation of both assets using an MPEEM
approach is commonly accomplished by excluding backlog revenue and operating profit from the
customer relationship valuation. An additional consideration (though it is an accounting consideration
rather than a valuation consideration) is the post-transaction amortization. When straight-line amortization
is used rather than the pattern of economic benefit, it is common to begin amortizing all assets in the first
period. This will lead to concurrent amortization in periods where both backlog and other customer-related
assets exist. As a result, it is not uncommon to group backlog and customer relationship value estimates
into a single valuation model.
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9.3 Deferred Revenue
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9.3.1 Deferred revenue is a liability (either current or non-current) that arises from the accounting for
transactions in which a customer pays for goods or services in advance of the delivery of such goods or
services and there is a remaining performance obligation. The undelivered performance obligation
becomes a liability at the time of the transaction and is recognized as revenue once the performance
obligation is fulfilled. Common examples are computer service contracts, software maintenance contracts,
or other extended service contracts where the contract is paid at inception but the performance obligation
will be delivered over the term of the contract, which causes the entity to defer recognition of revenue.
9.3.2 The presence of deferred revenue when valuing an intangible asset such as customer-related assets
or technology-related assets can create the need for adjustments to the cash flows to ensure there is not
double counting. Specifically, the valuation of the deferred revenue (which typically arises in a business
combination or a goodwill impairment step two analysis) considers the costs to fulfill the performance
obligation and the related profit on those efforts. It is important to make sure that those costs and profits
are not measured in another intangible asset such as customer-related or technology-related assets so that
the liability is not netted with an asset.
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9.3.3
In most cases, the PFI prepared by management is developed on an accrual basis. In the presence
of deferred revenue, this can create the need for adjustments to be made because a portion of the projected
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revenue will have already been received in cash. The Working Group believes there are generally three
alternatives for making deferred revenue-related adjustments:
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a. In Method 1, the accrual PFI can be converted to a cash-basis PFI. Using a cash-basis PFI would
not require a need for any adjustments because revenue is not deferred in cash-basis accounting.
b. In Method 2, adjust the accrual-based PFI in a MPEEM to exclude the book value of deferred
revenue,27 and remove the fulfillment cost from the Cost of Goods Sold (COGS) and operating
expenses. By eliminating the deferred revenue and the fulfillment cost from the MPEEM, double
counting is avoided.
c. In Method 3, in situations where the amount of revenue from existing customers that is deferred
each year is expected to be relatively consistent or the amount of revenue deferred each year is
minimal as compared with total annual revenue, as a practical expedient no adjustments for
deferred revenue or related fulfillment expenses are made in the customer-related asset valuation
model. The timing impact on cash flows is considered to be de minimis.
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9.3.4 The Working Group believes that Methods 2 and 3 are more practical expedients, as converting
accrual accounting PFI to cash basis may be a complex task. Key adjustments in Method 2 include:
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a. Projected revenue should represent revenue from future sales only (i.e., revenue that has not yet
been received). Thus, the amount of revenue that is deferred (book value) should be excluded from
the MPEEM because it has already been received and the cost associated with fulfilling the
performance obligation associated with the deferred revenue is valued as a liability.
b. The cost of goods sold should be based on the revenue from future sales only.
c. The working capital CAC should reflect debt-free working capital, including deferred revenue and
the related cash.
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9.3.5 Example 9.1 below is a simplified example that highlights the important consideration of the
relationship between the customer relationship asset and deferred revenue liability values.
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Example 9.1: Adjustments for Deferred Revenue
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9.3.6 A basic bottom-up valuation of deferred revenue is shown below. The full-year revenue for the
entity is forecast to be $5,000 and $1,000 is deferred revenue as of the valuation date.
27 Excluding the book value of the deferred revenue means that the MPEEM should include only the revenue that was not
deferred in year one (or more years if deferred revenue is long term).
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Valuation of Deferred Revenue
Bottom-Up
Approach
Percentage
of Book
Value
Book Value
1,000
100%
COGS (Fulfillment)
Selling & Marketing (1)
R&D
Cost to Fulfill
Profit on Fulfillment
Fair value
Assumptions:
EBITA Margin
Convert to Profit on Cost
70%
10%
0%
80%
18%
88%
700
-
-
700
175
875
20%
25%
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Comments:
(1) Selling & Marketing is not considered a fulfillment-related cost.
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9.3.7 Below is an illustration of the adjustments discussed above using a one-year MPEEM model.
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a. The MPEEM only includes the revenue from future sales.
b. COGS and Selling & Marketing are based on the $4,000 revenue from future sales.
c. In the profit and loss statement, total revenue equals the fair value of the deferred revenue plus the
revenue from future sales.
The COGS is $2,800, which is the $3,500 in COGS prior to adjustment less the fulfillment cost in
the deferred revenue valuation ($700).
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MPEEM Adjustments - Correct
Revenue Deferred at Book Value
Revenue from Future Sales (1)
Total Revenue
COGS (2)
Selling & Marketing (S&M) (3)
R&D (4)
EBITA (c1)
EBITA Margin
Customer
MPEEM
Year 1
Year 1
1,000
4,000
5,000
(3,500)
(500)
-
1,000
20%
-
4,000
4,000
(2,800)
(400)
-
800
20%
Comments:
(1) Deferred revenue at book value is excluded from the customer asset model.
(2) COGS in the MPEEM are based on the revenue from future sales only (70%*4,000).
(3) S&M in the MPEEM are based on the revenue from future sales only (10%*4,000).
(4) There are various practices regarding the inclusion of R&D expense in
deferred revenue valuations. For the purposes of this example, R&D has
not been included in the deferred revenue valuation.
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9.3.8 Below is a second commonly used calculation for adjusting the same one-year MPEEM model
that the Working Group does not believe to be correct.
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a. Revenue appropriately excludes the deferred revenue.
b. COGS are calculated as the deferred revenue fulfillment costs plus the COGS on revenue from
future sales. This is a double count because the fulfillment costs are already measured in the
deferred revenue liability (or fair value). The result is an understated value of the asset being
valued with the MPEEM (note that the adjusted Earnings Before Interest, Taxes and Amortization
[EBITA] margin is below the unadjusted base margin), which will have the effect of overstating
the profit in the income statement.
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MPEEM Adjustments - Incorrect
Revenue Deferred at Book Value
Revenue from Future Sales (1)
Total Revenue
COGS (2)
Selling & Marketing
R&D
EBITA
EBITA Margin (2)
Customer
MPEEM
Year 1
Year 1
1,000
4,000
5,000
(3,500)
(500)
-
1,000
20%
-
4,000
4,000
(3,500)
(400)
-
100
3%
Comments:
(1) Deferred revenue at fair value is excluded from the customer asset model.
(2) COGS are based on total revenue, inclusive of deferred revenue. Profit related
to the asset is reduced significantly because the fulfillment cost is double-counted.
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9.3.9 Method 1 is obtaining a cash-based PFI from management or converting the accrual-based cash
flows to cash basis for use in the MPEEM. Conversion of accrual-based revenue may not be overly
complicated, but management would likely have to provide a number of key data points. The advantages
of using a cash-basis PFI are:
a. There is no need to make any adjustments for deferred revenue because in cash-basis accounting,
deferred revenue would not exist.
b. The CAC for working capital would only include operating cash and inventory.
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9.3.10 The disadvantages of using this approach include:
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a. The appropriate information must be obtained to make the conversion, assuming management does
not have a cash-basis PFI readily available.
b. Customer attrition is based on historical revenue data that is most likely recorded based on the
subject company’s accrual accounting. The result may be that attrition rates are not appropriately
matched to the revenue projections being used.
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9.3.11 The Working Group believes that Method 2 above is a more practical expedient and more
commonly used in the valuation profession.
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9.4 Step-Up Considerations for Inventory
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9.4.1 When valuing customer-related assets using the MPEEM, the valuation specialist must often
consider how to account for the fair value of inventory and its associated step-up in determining the
appropriate earnings and cash flow, as well as the CAC related to working capital. It is generally accepted
practice to calculate CACs based on the fair value of the contributory assets used in generating the
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revenue, earnings, and cash flows relating to the asset being valued. According to VFR Valuation
Advisory #1, valuation specialists should not only exclude one-time adjustments from market participant
levels of working capital used in the CAC calculation, but should also make sure to adjust for the effects
of any one-time modifications of the PFI utilized in the valuation of the subject intangible asset to avoid
double counting profit or expense. More specifically, the profit included in the inventory step-up (if
applied) would need to be removed from the PFI of the subject intangible asset so that the profit is not
recognized more than once.28
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9.4.2
In practice, the Working Group has found that the statement above can be interpreted in multiple
ways. It is the Working Group’s view that, in valuing the customer-related assets, the inventory step-up
should be included as an expense in the PFI used in the MPEEM and related adjustments should be made
to the level of contributory asset charges. Furthermore, the CACs should be based on market participant
levels and exclude the impact of one-time adjustments.
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9.4.3 Example 9.2 below outlines a calculation to incorporate the inventory step-up in an MPEEM. The
inventory step-up is the difference between the fair value and book value of the inventory. For illustration
purposes, it was assumed there is no work-in-process (WIP) inventory and that last-in first-out (LIFO)
accounting is used.
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Example 9.2: Adjustment for Inventory Step-up
Inventory Summary
Book Value Fair Value
Step-up
Step-up (%)
Inventory - Finished Goods
Inventory - Raw Materials
Total
160.0
10.0
170.0
170.0
10.0
180.0
10.0
-
10.0
6.3%
0.0%
5.9%
Comments:
> The fair value of finished goods inventory reflects its net realizable value, which equals net selling price less disposition costs
and profit on disposition activities.
> Raw materials inventory is valued based on its replacement cost.
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9.4.4
It is important to understand that the inventory step-up reflects costs and profits associated with
manufacturing of inventory and that in a MPEEM, the profits on these activities are also reflected as
CACs in the forms of returns on and of Property, Plant & Equipment (PP&E), working capital, workforce,
and potentially other assets.
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9.4.5 The table below shows the impact of the inventory step-up on a MPEEM under several common
scenarios. For simplicity, it is assumed that the inventory step-up only impacts year 1 of the MPEEM.
Each method is described below:
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a. “Year 1 No Step-up” scenario – Shows the cash flow derived from customer-related assets without
the impact of the inventory step-up. The CACs are also not adjusted. It is assumed that the entity is
operating in a normal fashion and the profit associated with the manufacturing operation is already
embedded in the CACs. Because the profit associated with manufacturing operations is captured in
28 The Appraisal Foundation, VFR Valuation Advisory #1, 14.
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both the inventory and the CACs, the Working Group believes this approach may be inappropriate
for use in situations where the step-up in inventory is not completely offset by the CACs.
b. “Year 1 Step-up” scenario – Shows the cash flow derived from customer-related assets with the
impact of the inventory step-up. The CACs are not adjusted. The Working Group believes that this
approach double counts the manufacturing-related profit as it is included in the inventory step-up
and in the manufacturing-related CACs. Therefore, the cash flow in the MPEEM is incorrectly
understated.
c. “Blended” scenario – Shows the aggregate cash flow derived from customer-related assets (i.e., it
is a summation of the “Existing Inventory” and “Future Inventory” columns). This scenario can be
compared with the “Year 1 No Step-up” and “Year 1 Step-up” scenarios. It is the Working
Group’s view that the “Blended” scenario best reflects the expected future cash flow resulting
from the customer-related assets since revenues related to finished goods inventory have the
appropriate adjustments for the inventory step-up and CACs (“Existing Inventory” column) and
revenue associated with future inventory is reflective of the levels of CACs needed to support it
(“Future Inventory” column). Additional detail on the “Existing Inventory” and “Future Inventory”
columns is below:
i.
“Existing Inventory” column – Shows the cash flow derived from customer-related assets
relating only to revenue from the sale of finished goods inventory (i.e., depreciation,
PP&E, and assembled workforce requirements as a percentage of revenue are reduced to
reflect the fact that the inventory has already been manufactured—these adjustments are
based on an assessment of the amount of PP&E and other assets that are utilized for non-
manufacturing activities). The MPEEM is adjusted for the impact of the inventory step-up
(the step-up is applied as an expense) and CACs are adjusted to reflect non-manufacturing
activities to avoid a double counting of profit. In the example below, 20% of PP&E and
workforce are associated with the distribution effort and therefore in the “Existing
Inventory” column, depreciation and the PP&E and workforce CACs (as a percentage of
revenue) reflect 20% of the respective total company assumptions.
ii.
“Future Inventory” column – Shows the cash flow derived from customer-related assets
relating only to revenue from the sale of inventory not yet manufactured. The MPEEM has
no adjustment for the inventory step-up and CACs are also unadjusted, other than to be
scaled for their utilization (on a percentage of revenue basis).
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Inventory Step-up Adjustment
Revenue by Inventory Type
COGS
Inventory Step Up
Gross Profit
SG&A
EBITDA
Depreciation
EBITA
EBITA Margin
Income Taxes
Debt-Free Net Income
After-Tax Return on Supporting Assets
Working Capital
Property, Plant & Equipment
Assembled Workforce
Total After-Tax Returns
Net Cash Flow to Customer Relationships
Implied Royalty Rate
Assumptions
(As as percentage of revenue)
COGS
COGS (with Inventory Step Up)
SG&A
EBITDA Margin
Depreciation
Tax Rate
Working Capital to Revenue
Return on Working Capital
PP&E to Revenue
Return on PP&E
Assembled Workforce CAC
PP&E Allocation
Manufacturing Function
Distribution Function
Year 1
No Step-up
Scenario
Year 1
Step-up
Scenario
Existing
Inventory
Future
Inventory
Blended
Blended Scenario
1,000.0
(800.0)
-
200.0
(100.0)
100.0
(30.0)
70.0
7.0%
(28.0)
42.0
4.2%
(6.0)
(15.0)
(10.0)
(31.0)
11.0
1.10%
1,000.0
(800.0)
(10.0)
190.0
(100.0)
90.0
(30.0)
60.0
6.0%
(24.0)
36.0
3.6%
(6.0)
(15.0)
(10.0)
(31.0)
5.0
0.50%
200.0
(160.0)
(10.0)
30.0
(20.0)
10.0
(1.2)
8.8
4.4%
(3.5)
5.3
2.6%
(1.2)
(0.6)
(0.4)
(2.2)
3.1
1.54%
800.0
(640.0)
-
160.0
(80.0)
80.0
(24.0)
56.0
7.0%
(22.4)
33.6
4.2%
(4.8)
(12.0)
(8.0)
(24.8)
8.8
1.10%
1,000.0
(800.0)
(10.0)
190.0
(100.0)
90.0
(25.2)
64.8
6.5%
(25.9)
38.9
3.9%
(6.0)
(12.6)
(8.4)
(27.0)
11.9
1.19%
Blended Scenario
Year 1
No Step-up
Scenario
Year 1
Step-up
Scenario
Existing
Inventory
Future
Inventory
Blended
80.0%
81.0%
10.0%
9.0%
3.0%
40.0%
10.0%
6.0%
15.0%
10.0%
1.0%
80.0%
85.0%
10.0%
5.0%
0.6%
40.0%
10.0%
6.0%
3.0%
10.0%
0.2%
80.0%
80.0%
10.0%
10.0%
3.0%
40.0%
10.0%
6.0%
15.0%
10.0%
1.0%
80.0%
81.0%
10.0%
9.0%
2.5%
40.0%
10.0%
6.0%
12.6%
10.0%
0.8%
80.0%
80.0%
10.0%
10.0%
3.0%
40.0%
10.0%
6.0%
15.0%
10.0%
1.0%
20.0%
80.0%
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9.5 Overlapping Customers
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9.5.1 Overlapping customers exist when an acquirer purchases an acquiree that has many of the same
customers. For example, Company A sells football equipment to Retailers L, M and O. Company A
acquires Company B, a maker of soccer equipment, in a business combination and Company B also sells
its products to L, M and O. Historically, some entities argued that Company B's customers should not be
recognized at fair value because Company A already had established relationships with L, M and O and it
did not gain new customer relationships. The counterargument that was highlighted in an SEC speech29
stated that Company A had likely gained shelf space at the retailers and enhanced its economic
relationships as it would now receive incremental cash flows resulting from Company B's relationships.
The key take away from the speech is that the economics of customer-related assets from a market
participant perspective are the most important consideration (assuming they meet the contractual-legal or
separable criteria) rather than the nature of the relationships on an entity-specific basis.
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9.6 Pre-Existing Relationships in a Business Combination
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9.6.1 ASC (equivalent discussion in IFRS 3R [B51-B53]) states that an
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acquirer and the acquiree may have a preexisting relationship or other arrangement before negotiations for the
business combination began, or they may enter into an arrangement during the negotiations that is separate from
the business combination. In either situation, the acquirer shall identify any amounts that are not part of what
the acquirer and the acquiree (or its former owners) exchanged in the business combination, that is, amounts
that are not part of the exchange for the acquiree. The acquirer shall recognize as part of applying the
acquisition method only the consideration transferred for the acquiree and the assets acquired and liabilities
assumed in the exchange for the acquiree. Separate transactions shall be accounted for in accordance with the
relevant generally accepted accounting principles (GAAP).30
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9.6.2
In addition to the language above, ASC 805 and IFRS 3R provide the following example for the
effective settlement of a supply contract as a result of a business combination (use of the word “Target” in
the quote below indicates the acquiree):
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Acquirer purchases electronic components from Target under a five-year supply contract at fixed rates.
Currently, the fixed rates are higher than rates at which Acquirer could purchase similar electronic components
from another supplier. The supply contract allows Acquirer to terminate the contract before the end of the initial
5-year term only by paying a $6 million penalty. With 3 years remaining under the supply contract, Acquirer
pays $50 million to acquire Target, which is the fair value of Target based on what other market participants
would be willing to pay.31 (similar language is found in IFRS 3R [IE54])
Included in the total fair value of Target is $8 million related to the fair value of the supply contract with
Acquirer. The $8 million represents a $3 million component that is at-market because the pricing is comparable
to pricing for current market transactions for the same or similar items (selling effort, customer relationships,
and so forth) and a $5 million component for pricing that is unfavorable to Acquirer because it exceeds the price
of current market transactions for similar items. Target has no other identifiable assets or liabilities related to the
29 Remarks made by SEC professional accounting fellow Pamela Schlosser at the 2005 AICPA National Conference on Current
SEC and PCAOB Developments.
30 Accounting Standards Codification™ 805-10-25-20.
31 Accounting Standards Codification™ 805-10-55-30.
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supply contract, and Acquirer has not recognized any assets or liabilities related to the supply contract before
the business combination.32 (similar language is found in IFRS 3R [IE55])
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9.6.3
“In this Example, Acquirer recognizes a loss of $5 million (the lesser of the $6 million stated
settlement amount and the amount by which the contract is unfavorable to the acquirer) separately from
the business combination. The $3 million at-market component of the contract is part of goodwill.”33
(similar language is found in IFRS 3R [IE56])
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9.6.4 The Working Group believes that although this example discusses customer contracts, non-
contractual customer relationships would be treated similarly and would not lead to the recognition of an
identifiable intangible asset because customer relationships do not meet the definition of a reacquired
right.
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9.7 Asset Life and Amortization
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9.7.1 The life of an asset can be defined in two ways: economic life and useful life. Economic life is a
valuation concept, while useful life is an accounting estimate. Economic life and useful life are discussed
further below.
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a. Economic Life – Economic life has various (albeit similar) definitions in existing valuation
literature. For the purposes of this document, economic life is defined as “the total period of time
over which an asset is expected to generate economic benefits for one or more users.”34 In an
income approach, the economic life is equal to the period over which cash flows are projected and
are based on a perspective of a market participant. The fair value of an asset is equal to the sum of
the present value of cash flows expected to be generated by the asset over its economic life.
For backlog-type assets, management will often have contract terms or other reliable estimates of
order fulfillment to estimate the economic life. For contractual customer relationships, the
economic life is generally based on the contractual term plus any expected renewals, which should
be consistent with the provisions of the contract and market participant assumptions. For non-
contractual relationship assets, the economic life is less obvious and its determination typically
requires further analysis, such as an attrition analysis.
b. Useful Life – ASC 350 (and IAS 38 [88-96]) states that “the accounting for a recognized intangible
asset is based on its useful life to the reporting entity” (ASC 350-30-35-1). ASC 350 defines the
useful life of an intangible asset as “the period over which the asset is expected to contribute
directly or indirectly to the future cash flows of that entity” (ASC 350-30-35-2). While this
definition is similar to that of economic life, the Working Group believes there could be
differences between economic life and useful life since the useful life determination is an entity-
specific determination and the economic life relates to market participant assumptions contained in
the valuation model. ASC 350 provides additional guidance for evaluating useful life by stating
that “The useful life of an intangible asset to an entity is the period over which the asset is
expected to contribute directly or indirectly to the future cash flows of that entity. The useful life is
32 Accounting Standards Codification™ 805-10-55-31.
33 Accounting Standards Codification™ 805-10-55-32.
34 International Valuation Standards Council International Valuation Glossary, significantly based on the definition from the
International Glossary of Business Valuation Terms, which was adopted by the American Institute of Certified Public
Accountants, the American Society of Appraisers, the National Association of Certified Valuation Analysts, the Canadian
Institute of Chartered Business Valuators, and the Institute of Business Appraisers.
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not the period of time that it would take that entity to internally develop an intangible asset that
would provide similar benefits” (ASC 350-30-35-2). ASC 350 also provides guidance on what
factors one should consider when determining the useful life of an asset for a given entity (ASC
350-30-35-3).
The useful life of an intangible asset is categorized as either finite or indefinite. An indefinite-lived
intangible asset is not amortized; rather, it is tested annually for impairment. Intangible assets with
a finite life are amortized. ASC 350 specifies that “the method of amortization shall reflect the
pattern in which the economic benefits of the intangible asset are consumed or otherwise used up.
If that pattern cannot be reliably determined, a straight-line amortization method shall be used”
(ASC 350-30-35 and IAS 38 [97]).
Depending on the methodology used to select a useful life, the useful life may differ significantly
from the economic life. Example 9.3 illustrates the relationship between the economic life and
potential useful lives of an asset and the resulting possible annual amortization schedules based on
the pattern of benefits and straight-line methodologies. The pattern of benefits amortization is
based on the pattern of annual undiscounted cash flows relative to the sum of all undiscounted cash
flows over the economic life of the asset. The straight line amortization is based on the value of the
asset, a qualitative assessment of the useful life, and constant annual amortization through the
useful life of the asset. The Working Group notes that although the following example utilizes
undiscounted cash flows to estimate the pattern of benefits, the selection of cash flows utilized to
make this estimation is an accounting policy determination.
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Example 9.3: Amortization Patterns
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9.7.2 Company A, an international manufacturer and marketer of widgets, acquires Company B, a
regional marketer of widgets. The primary acquisition rationale is access to the target’s customers.
Company B has significant market penetration in the southeastern US. The customer relationships are
transactional (i.e., purchase order-based and no long-term contracts exist). The value of the customer
relationships, assuming a 15% discount rate, is $480.47 million over a 20-year economic life. The
economic life ends when the discounted cash flows occurring after the economic life are immaterial to the
fair value conclusion.
9.7.3 Based on guidance provided in ASC 350, the customer relationships would be amortized in a
manner that would reflect the pattern in which the economic benefits of the intangible asset are consumed
or otherwise used up. However, in practice many companies use a straight-line amortization method that
approximates the effect of an amortization technique based on the pattern of benefits. The table below
summarizes the undiscounted cash flow, discounted cash flow, amortization over the expected pattern of
benefits, and the straight-line amortization over 12, 14, and 16 years. This table is intended to show the
differences between possible amortization techniques. Although the table below displays a comparison of
the different amortization techniques, the method selected is an accounting issue that is determined by
management and reviewed/discussed with their auditors.
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Table 9.1: Economic versus Useful Life (in $millions)
Economic Life
Useful Life
Undiscounted
Cash Flows
Discounted
Cash Flows
Pattern of
Benefits
Amortization (1)
Straight-Line Amortization (2)(3)
12 Years
14 Years
16 Years
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Year 11
Year 12
Year 13
Year 14
Year 15
Year 16
Year 17
Year 18
Year 19
Year 20
Total
100.00
93.00
86.49
80.44
74.81
69.57
64.70
60.17
55.96
52.04
48.40
45.01
41.86
38.93
36.20
33.67
31.31
29.12
27.08
25.18
93.25
75.41
60.98
49.32
39.89
32.25
26.08
21.09
17.06
13.79
11.16
9.02
7.30
5.90
4.77
3.86
3.12
2.52
2.04
1.65
40.04
40.04
40.04
40.04
40.04
40.04
40.04
40.04
40.04
40.04
40.04
40.04
34.32
34.32
34.32
34.32
34.32
34.32
34.32
34.32
34.32
34.32
34.32
34.32
34.32
34.32
30.03
30.03
30.03
30.03
30.03
30.03
30.03
30.03
30.03
30.03
30.03
30.03
30.03
30.03
30.03
30.03
43.92
40.85
37.99
35.33
32.86
30.56
28.42
26.43
24.58
22.86
21.26
19.77
18.38
17.10
15.90
14.79
13.75
12.79
11.89
11.06
1,093.94
480.46
480.49
480.48
480.48
480.48
1897
Notes:
1898
1899
1900
1901
1902
(1) Pattern of Benefits = Undiscounted Cash Flow in Year / Total Undiscounted Cash Flow x Total
Present Value. Year 1 example calculation: 100.00 / 1,093.94 x 480.47 = 43.92.
(2) Straight-Line Amortization = Total Present Value / Number of Years of Straight-Line
Amortization. Year 1 example calculation (assuming a 12-year straight-line amortization period):
480.47 / 12 = 40.04.
1903
(3) Years 12, 14, and 16 are included only for illustrative purposes.
1904
1905
1906
1907
9.7.4 The graph below (based on the table above) illustrates the total cumulating amount amortization
using (a) the pattern of benefits technique and straight-line techniques with lives of (b) 12, (c) 14, and (d)
16 years. In this example, a 12-year straight-line amortization appears to be the closest proxy to the pattern
of benefits in the earlier years while the 16-year straight-line amortization appears to be the best proxy in
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1909
1910
1911
1912
the later years. This chart indicates that certain amortization techniques may be more appropriate than
others depending on facts and circumstances. For instance, straight-line amortization patterns are shown
here as an example, but other techniques such as declining balance or sinking-fund may also be
appropriate to consider. As mentioned above, this determination should be made by management and
reviewed/discussed with their auditors.
1913
Figure 9.1: Amortization Patterns
Amortization Patterns
n
o
i
t
a
z
i
t
r
o
m
A
e
v
i
t
a
u
m
u
C
l
600
500
400
300
200
100
‐
1
2
3
4
5
6
7
9
10
8
13
Projection Period (in years)
11
12
14
15
16
17
18
19
20
Pattern of Benefits
12‐Year Straight‐Line
14‐Year Straight‐Line
16‐Year Straight‐Line
1914
1915
1916
1917
1918
1919
1920
1921
9.7.5
It is generally straightforward to identify economic and useful life patterns when an income
approach is used to value customer-related assets. However, when other approaches are used, such as a
cost approach, the issue can be more difficult to assess. When using a cost approach, the historical
expense or cost pattern relied upon does not have any correlation to the life of the customer-related asset
itself. Initial costs, as well as any ongoing maintenance costs, both need to be considered when
determining the economic life of the customer-related asset. When using a with and without approach, the
rebuild period in the without approach does not have any correlation to the life of the customer-related
asset itself.
1922
9.8 Testing Outputs
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9.8.1
In the context of the estimation of asset values in a business combination, there are several ways
to “test” the output of a customer-related asset valuation for reasonableness. The following high-level
procedures can be helpful in assessing the value of customer relationships.
1926
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1931
1932
1933
1934
1935
1936
1937
1938
1939
1940
1941
1942
1943
1944
1945
1946
1947
1948
1949
1950
1951
1952
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1956
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1958
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1960
1961
1962
1963
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1965
a. Output versus Expectation – Customer value should be assessed relative to qualitative expectations
at the outset of an engagement. Given our qualitative view, does the quantitative answer make
sense? Can we compare the output to prior experience (i.e., customer value as a percentage of
purchase consideration and/or total intangible asset value including goodwill)? How does the
customer value compare to the value of other assets in the context of the qualitative considerations
discussed above? Is the value derived for the customer-related asset consistent with the importance
of the asset and language used to describe the asset in any press releases discussing the
transaction? Is it a primary or secondary asset and are the approaches used consistent with
management’s view of the customer relationship asset?
b. Implied New Customer Assumptions – Given forecasts of overall revenue for the subject business
and forecasts of revenue attributable to existing customers, a forecast of revenue attributable to
future customers can be implied. This future customer revenue forecast should be assessed for
reasonableness. For instance, are implied growth rates realistically attainable given the sales and
marketing expense assumptions? The total industry customer population can be used to calculate
implied incremental market share captured each year. Are these results reasonable?
c. Reconciliation – A number of reconciliation tests can be performed, which will assist with the
assessment of customer value and, in some cases, other asset values. Profit margins for existing
and new customers should reconcile to the margins associated with the business. Does the profit
margin reconciliation make sense and tie back to the total? Sales and marketing expenses for
existing and new customers should tie to the total sales and marketing expense assumptions used
by the business. Are these assumptions consistent with each other?
d. Other Assumptions – Certain other assumptions in a customer model may infer information about
the value of existing customers, and the resulting customer value should be assessed relative to
these inferences. For example, in the MPEEM it may be appropriate to add back expenses
associated with new customer acquisitions (see discussion above). All else equal, if new customer
acquisition costs are relatively high, it may be reasonable to expect a higher value for existing
customers because of the implied investment required to have attracted them. Given new customer
acquisition costs, does the value for existing customers make sense? Does the revenue contribution
or profit contribution from existing versus new customers make sense?
9.8.2 When testing outputs, a valuation specialist may also need to address the existence of significant
negative cash flows in the customer relationship model. This may result in very little or no value being
assigned to the customer relationship asset. In cases where this occurs, the valuation specialist should
attempt to ascertain the driver of this result—for example, perhaps the valuation specialist should revisit
the CACs applied in the model. Alternatively, perhaps the company is investing in a new business
ecosystem that is expected to lead to value creation beyond the life of the existing customer base (e.g.,
through incremental future customers or profitability) and therefore the expected negative cash flows in
the model are justified from an operational perspective. In any case, the valuation specialist should ensure
that there is adequate support and/or justification for significant negative cash flows in the MPEEM, or
alternatively perhaps reconsider the appropriateness of the MPEEM as a valuation methodology given the
facts and circumstances.
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9.8.3 The financial overlay presented in the VFR Valuation Advisory #1 toolkit may be helpful to a
valuation specialist when assessing the consistency and output of asset valuations in the context of a
business combination.
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1968
1969
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10.0 Summary
1971
1972
10.1.1 There are multiple situations that require the valuation of customer-related assets for financial
reporting purposes, including:
1973
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1975
1976
1977
a. Business combinations;
b. Asset acquisitions;
c. Goodwill impairment testing;
d. Long-lived asset impairment testing; and
e. Reorganizations.
1978
1979
10.1.2 The Working Group believes that asset identification and qualitative considerations are equally as
important as the selection of valuation methodology and quantitative factors.
1980
1981
1982
1983
10.1.3 Customer-related assets, like other intangible assets, must meet certain criteria to be recognized
for financial reporting purposes. ASC 805 continues the guidance set forth in prior US GAAP where
identifiable assets are recognized if they are contractual, arise from legal rights, or are separable and can
be sold, rented, or leased (ASC 805-20-55, IFRS 3R [Appendix A]).
1984
1985
1986
1987
1988
1989
10.1.4 There are three standard approaches a valuation specialist may consider in the valuation of
customer-related assets: the income approach, the cost approach, and the market approach. The income
approach is the most common approach used in the valuation of customer-related assets and is viewed by
the Working Group as the preferred methodology in most situations. However, in the valuation process,
the methodology selected or the model chosen should reflect careful qualitative and quantitative
assessment of the asset.
1990
1991
10.1.5 Factors to consider for the purpose of gaining a qualitative understanding of the customer-related
asset include: industry, company, product/service, and customer-related asset characteristics.
1992
1993
1994
1995
10.1.6 The income approach is used to estimate fair value based on the cash flows that an asset can be
expected to generate over its economic life. The most commonly used income approach methods include
the MPEEM, the Distributor Method (a variant of the MPEEM), the With-and-Without Method, and the
Cost Savings Method.
10.1.7 Many implementation issues arise in the valuation of customer-related assets. This document
seeks to highlight these issues and set forth the Working Group’s view of best practices. The Working
Group notes that professional judgment is necessary in the valuation of any asset and that the purpose of
this document is to assist in reducing diversity of practice in the specific topics addressed by the Valuation
Advisory. It is the goal of the Working Group that the guidance set forth in this Valuation Advisory,
combined with the application of professional judgment, will result in measurements of fair value that
represent the highest level of professional practice and that are consistent with the goals of fair value
measurement for financial reporting.
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1997
1998
1999
2000
2001
2002
2003
2004
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2005
11.0 LIST OF ACRONYMS USED
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
2035
2036
2037
2038
2039
2040
2041
2042
2043
2044
2045
2046
2047
2048
AICPA
A/P
A/R
ASC
ASU
CAC
CAGR
CAPEX
CAPM
CGU
COGS
EBITA
EBITDA
EITF
FAS
FASB
FSP
GAAP
IAS
IASB
IFRIC
IFRSs
IP
IPR&D
IRR
IVS
IVSC
MPEEM
NOL
PCAOB
PFI
PP&E
PV
R&D
ROI
RUL
SEC
SG&A
S&M
TAB
VIU
WACC
WARA
American Institute of Certified Public Accountants
Accounts Payable
Accounts Receivable
Accounting Standards CodificationTM
Accounting Standards Update
Contributory Asset Charge
Compound Annual Growth Rate
Capital Expenditure
Capital Asset Pricing Model
Cash-Generating Unit
Cost of Goods Sold
Earnings Before Interest, Taxes and Amortization
Earnings Before Interest, Taxes, Depreciation and Amortization
Emerging Issues Task Force
Financial Accounting Standard
Financial Accounting Standards Board
FASB Staff Position
Generally Accepted Accounting Principles
International Accounting Standard
International Accounting Standards Board
International Financial Reporting Standards Interpretations Committee
International Financial Reporting Standards
Intellectual Property
In-Process Research & Development
Internal Rate of Return
International Valuation Standards
International Valuation Standards Council
Multi-Period Excess Earnings Method
Net Operating Loss
Public Company Accounting Oversight Board
Prospective Financial Information
Property, Plant & Equipment
Present Value
Research and Development
Return on Investment
Remaining Useful Life
Securities and Exchange Commission
Selling, General & Administrative
Selling & Marketing
Tax Amortization Benefit
Value in Use
Weighted Average Cost of Capital
Weighted Average Return on Assets
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WC
WIP
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Working Capital
Work-in-Process
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12.0 REFERENCES
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Financial Accounting Standards Board. Financial Accounting Series, Statement of Financial Accounting
Standards No. 141 (Revised 2007) – Business Combinations. Norwalk, CT: 2007. (now ASC 805)
Financial Accounting Standards Board. Financial Accounting Series, Statement of Financial Accounting
Standards No. 142 – Goodwill and Other Intangible Assets. Norwalk, CT: 2001. (now ASC 350)
2057
2058
2059
Financial Accounting Standards Board. Financial Accounting Series, Statement of Financial Accounting
Standards No. 144 – Accounting for the Impairment or Disposal of Long-Lived Assets. Norwalk, CT:
2001. (now ASC 360)
2060
2061
2062
2063
Financial Accounting Standards Board. Financial Accounting Series, Statement of Financial Accounting
Standards No. 157 – Fair Value Measurements. Norwalk, CT: 2010. (now ASC 820)
Financial Accounting Standards Board. EITF 01-3, Accounting in a Business Combination for Deferred
Revenue of an Acquiree. 2008. (nullified and subsumed into ASC 805)
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Financial Accounting Standards Board. EITF 02-17, Recognition of Customer Relationship Intangible
Assets Acquired in a Business Combination. 2008. (nullified and subsumed into ASC 805)
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2067
Financial Accounting Standards Board. Staff Position No. FAS 142-3, Determination of the Useful Life of
Intangible Assets. 2008.
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Financial Accounting Standards Board. Accounting Standards CodificationTM. 2009.
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International Accounting Standards Committee Foundation. International Accounting Standard 36:
Impairment of Assets. London: 2008.International Accounting Standards Committee Foundation.
International Accounting Standard 38: Intangible Assets. London: 2008.
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2075
2076
2077
2078
2079
2080
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International Accounting Standards Committee Foundation. International Financial Reporting Standard
3: Business Combinations. London: 2011.
International Accounting Standards Committee Foundation. International Financial Reporting Standard
13: Fair Value Measurement. London: 2011.
International Glossary of Business Valuation Terms as adopted by the following professional societies and
organizations:
American Institute of Certified Public Accountants
American Society of Appraisers
National Association of Certified Valuation Analysts
The Canadian Institute of Chartered Business Valuators
The Institute of Business Appraisers
2083
International Valuation Standards Council. International Valuation Standards. London: 2013.
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Kim, Sandie E.. “Remarks Before the 2007 AICPA National Conference on Current SEC and PCAOB
Developments” (speech). Washington, DC: December 10, 2007.
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2087
Schlosser, Pamela R. “Remarks Before the 2005 AICPA National Conference on Current SEC and
PCAOB Developments” (speech). Washington, DC: December 5, 2005.
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2090
The Appraisal Foundation. VFR Valuation Advisory #1 - Best Practices for Valuations in Financial
Reporting: Intangible Asset Working Group – Contributory Assets, The Identification of Contributory
Assets and Calculation of Economic Rents. Washington, DC: The Appraisal Foundation, 2010.
Ucuzoglu, Joseph B. “Remarks Before the 2006 AICPA National Conference on Current SEC and
PCAOB Developments” (speech). Washington, DC: December 11, 2006.
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13.0 GLOSSARY
2095
13.1 Glossary of Terms
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2100
2101
Backlog
Arises from contracts such as purchase or sales orders. An order or production backlog acquired in a
business combination meets the contractual-legal criterion even if the purchase or sales orders are
cancelable.
(Source: Financial Accounting Standards Board Accounting Standards Codification Topic 805, Business
Combinations [formerly Statement of Financial Accounting Standards No. 141 (Revised 2007)])
2102
2103
2104
2105
2106
2107
2108
2109
2110
Capital Charge
A fair return on an entity’s contributory assets, which are tangible and intangible assets used in the
production of income or cash flow associated with an intangible asset being valued. In this context,
income or cash flow refers to an applicable measure of income or cash flow, such as net income or
operating cash flow before taxes and capital expenditures. A capital charge may be expressed as a
percentage return on [sic]35 an economic rent associated with, or a profit split related to, the contributory
assets.
(Source: AICPA Statement on Standards for Valuation Services, Appendix C, Glossary of Additional
Terms)
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2112
Contributory Asset Charge (CAC)
See Capital Charge.
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2115
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2119
2120
Customer List
Consists of information about customers, such as their names and contact information. A customer list
also may be in the form of a database that includes other information about the customers, such as their
order histories and demographic information. A customer list generally does not arise from contractual or
other legal rights. However, customer lists are frequently leased or exchanged. Therefore, a customer list
acquired in a business combination normally meets the separability criterion.
(Source: Financial Accounting Standards Board Accounting Standards Codification Topic 805, Business
Combinations [formerly Statement of Financial Accounting Standards No. 141 (Revised 2007)])
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2123
2124
2125
2126
Customer Relationship
A relationship that exists between an entity and its customer if the entity has information about the
customer and has regular contact with the customer, and the customer has the ability to make direct
contact with the entity.
(Source: Financial Accounting Standards Board Accounting Standards Codification Topic 805, Business
Combinations [formerly Statement of Financial Accounting Standards No. 141 (Revised 2007)])
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2130
Deferred Revenue
Deferred revenue is a liability that is created when monies are received by a company for goods and
services not yet provided. Revenue will be recognized, and the deferred revenue liability eliminated, when
the services are performed. Deferred revenue stems from the accounting concept of revenue recognition,
35 The word “or” would be more appropriate.
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2136
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2141
2142
under which revenues are recognized only when the earnings process is complete. If funds are received
and no goods or services have yet been provided, the process is not complete; thus revenue cannot be
recognized, and a deferred revenue liability is recorded. Specifically, the deferred revenue account is
credited, and cash (or other assets) are debited. Deferred revenue is recorded in specific industries under
particular circumstances. For instance, a software company might post deferred revenue for a maintenance
agreement under which services will be provided over several years.
(Source: www.investorglossary.com)
Economic Life
The total period of time over which an asset is expected to generate economic benefits for one or more
users.
(Source: International Valuation Standards Council International Valuation Glossary, based on the
definition in the International Glossary of Business Valuation Terms)
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2147
Fair Value
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.
(Source: Financial Accounting Standards Board Accounting Standards Codification Topic 820, Fair Value
Measurement [formerly Statement of Financial Accounting Standards No. 157])
2148
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2150
2151
Fixed Asset
Assets with a physical manifestation. Examples include land and buildings, plant and machinery, fixtures
and fittings, tools and equipment, and assets in the course of construction and development.
[Source: International Valuation Standards, 7th Ed]
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Going Concern
A business enterprise that is expected to continue operations for the foreseeable future.
(Source: International Valuation Standards Council International Valuation Glossary, based on the
definition in the International Glossary of Business Valuation Terms)
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Goodwill
An asset representing the future economic benefits arising from other assets acquired in a business
combination that are not individually identified and separately recognized.
(Source: Financial Accounting Standards Board Accounting Standards Codification Topic 805, Business
Combinations [formerly Statement of Financial Accounting Standards No. 141 (Revised 2007)])
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2164
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2166
In-Process Research and Development Project (IPR&D)
Intangible asset that is to be used or is used in R&D activities, including a specific IPR&D project. In
other words, an IPR&D project is an example of an IPR&D asset. However, in some cases, an IPR&D
project may comprise several IPR&D assets.
(Source: AICPA Accounting and Valuation Guide – Assets Acquired to Be Used in Research and
Development Activities, 2013)
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2168
2169
2170
In-Process Research and Development (IPR&D) Project
R&D project that has not yet been completed. IPR&D project is an example of an IPR&D asset.
(Source: AICPA Accounting and Valuation Guide – Assets Acquired to Be Used in Research and
Development Activities, 2013)
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2171
2172
2173
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Intangible Assets
An intangible asset is an asset (not including a financial asset) that lacks physical substance. As used in
ASC 805, the term intangible asset excludes goodwill.
(Source: Financial Accounting Standards Board Accounting Standards Codification Topic 805, Business
Combinations [formerly Statement of Financial Accounting Standards No. 141 (Revised 2007)])
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2178
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2180
Internal Rate of Return (IRR)
A discount rate at which the present value of the future cash flows of the investment equals the acquisition
cost of the investment.
(Source: International Valuation Standards Council International Valuation Glossary, based on the
definition in the International Glossary of Business Valuation Terms)
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2187
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2189
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2194
Market Participant
Buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of
the following characteristics:
a. They are independent of each other; they are not related parties, although the price in a related-
party transaction may be used as an input to a fair value measurement if the reporting entity has
evidence that the transaction was entered into at market terms.
b. They are knowledgeable, having a reasonable understanding about the asset or liability and the
transaction using all available information, including information that might be obtained
through due diligence efforts that are usual and customary.
c. They are able to enter into a transaction for the asset or liability.
d. They are willing to enter into a transaction for the asset or liability; they are motivated but not
forced or otherwise compelled to do so.
(Source: Financial Accounting Standards Board Accounting Standards Codification Topic 820, Fair Value
Measurement [formerly Statement of Financial Accounting Standards No. 157])
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2199
Non-Contractual Customer Relationship
A customer relationship acquired in a business combination that does not arise from a contract but may
nevertheless be identifiable because the relationship is separable.
(Source: Financial Accounting Standards Board Accounting Standards Codification Topic 805, Business
Combinations [formerly Statement of Financial Accounting Standards No. 141 (Revised 2007)]
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2202
2203
2204
2205
Prospective Financial Information (PFI)
Any financial information about the future. The information may be presented as complete financial
statements or limited to one or more elements, items, or accounts. A forecast of expected future cash
flows.
(Source: AICPA Accounting and Valuation Guide – Assets Acquired to Be Used in Research and
Development Activities, 2013)
2206
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2208
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2210
Rate of Return
An amount of income (loss) and/or change in value realized or anticipated on an investment, expressed as
a percentage of that investment.
(Source: International Valuation Standards Council International Valuation Glossary, based on the
definition in the International Glossary of Business Valuation Terms)
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Remaining Useful Life
For the purposes of this Valuation Advisory, see Useful Life.
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Tax Amortization Benefit
Tax relief available on amortization of the capitalized asset.
(Source: International Valuation Standards Council International Valuation Glossary)
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Useful Life
The period over which the asset is expected to contribute directly or indirectly to the future cash flows of
an entity.
(Source: Financial Accounting Standards Board Accounting Standards Codification Topic 350,
Intangibles—Goodwill and Other)
Weighted Average Cost of Capital (WACC)
A discount rate estimated by the weighted average, at market values, of the cost of all financing sources in
a business enterprise’s capital structure.
(Source: International Valuation Standards Council International Valuation Glossary)
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13.2 Glossary of Entities Referred to in Document
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American Institute of Certified Public Accountants (AICPA)
The national, professional organization for Certified Public Accountants in the US. Provides members
with resources, information, certification, and licensing. Established in 1887.
(Source: Derived from the AICPA’s website, www.aicpa.org)
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Emerging Issues Task Force (EITF)
Assists the FASB in improving financial reporting through the timely identification, discussion, and
resolution of financial accounting issues within the framework of the FASB ASC. Task Force members
are drawn from a cross section of the FASB’s constituencies, including auditors, preparers, and users of
financial statements. Established in 1984.
(Source: Derived from the FASB website, www.fasb.org)
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2241
Financial Accounting Standards Board (FASB)
The designated organization in the private sector for establishing standards of financial accounting and
reporting. Those standards govern the preparation of financial reports and are officially recognized as
authoritative by the SEC and AICPA.
(Source: Derived from the FASB’s website, www.fasb.org)
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2244
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2246
IFRS Interpretations Committee
Interpretive body with mandate to review on a timely basis widespread accounting issues that have arisen
within the context of current IFRSs. Work is aimed at reaching consensus on the appropriate accounting
treatment (IFRIC Interpretations) and providing authoritative guidance on those issues.
(Source: Derived from the IFRS Foundation website, www.ifrs.org)
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2250
International Accounting Standards Board (IASB)
London-based independent standard-setting body responsible for the development and publication of
IFRSs and for approving Interpretations of IFRSs as developed by the IFRS Interpretations Committee.
(Source: Derived from the IFRS Foundation website, www.ifrs.org)
International Valuation Standards Council (IVSC)
An independent, not-for-profit, private sector organization based in London, UK. The IVSC is a
membership organization and is open to a wide range of stakeholders including professional institutes,
valuation providers, standard setters, regulators of valuation services, and academia. Members are
provided with a forum for participation in the work of the IVSC, which can advise the Boards on agenda
priorities. The IVSC currently has 74 member bodies from 54 countries.
(Source: Derived from the IVSC website, www.ivsc.org)
US Securities and Exchange Commission (SEC)
Mission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital
formation in the United States. Established in 1934.
(Source: Derived from the SEC website, www.sec.gov)
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APPENDIX A: ATTRITION RATE CALCULATION EXAMPLES
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Attrition is discussed in Section 5.0 (Application of the Income Approach). Please note that the following
examples (A.1 through A.4) are separate and no numerical comparisons should be made between the
various examples. The data and years used in each example do not relate to one another.
2267
Example A.1: Historical Population Revenue and Customer Count Calculations
Attrition analyses using historical customer or revenue data begin with the collection of historical
customer population count or revenue losses or gains over a historical period of time. Since the attrition
data determined through the historical analysis is considered to be consistent across relationship vintages
and year groups, the survivor curve developed has the general characteristics of an exponential
distribution. When an exponential decay pattern is assumed, the assumed decay pattern for the current
customers is the same as that historically observed for the old customers. When estimating appropriate
customer attrition curves, it is important not only to develop a quantitative analysis but also to understand
the qualitative characteristics of the current customer group (average age, groups/vintages, etc.),
particularly as they compare to the historical customer population analyzed.
The following basic examples demonstrate the calculation of an attrition rate using historical customer
count data as well as customer revenue data. Revenue attrition incorporates two factors: the level of
revenue lost due to customer attrition and the level of revenue growth that occurs from retained customers.
As such, it can be measured in an aggregated or disaggregated manner. The disaggregated method
measures the customer attrition and revenue growth aspects separately. The aggregated method views
them together by measuring the level of revenue attributable to customers present at the start of the
measurement period.
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Table A.1.a: Historical Customer Population Data
Customer #
Time -5
Time -4
Time -3
Time -2
Time -1
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
$ 50,689
$ 51,196
$ 53,244
$ 54,575
$ 55,667
25,896
14,589
5,452
9,416
9,256
22,902
24,601
14,881
5,507
9,887
-
23,589
25,339
15,030
5,397
-
-
23,825
-
14,729
5,613
-
-
22,634
-
-
5,781
-
-
23,087
14,580
14,872
15,169
15,624
16,249
987
11,569
9,856
8,905
2,774
12,683
-
10,412
9,659
9,350
2,885
13,063
-
-
-
-
9,369
9,537
9,837
9,442
-
-
-
-
2,972
13,324
3,031
13,724
3,061
14,136
4,914
4,963
5,062
5,011
4,811
13,498
11,782
-
-
-
12,489
33,569
-
-
13,113
-
13,900
-
14,456
32,898
30,569
31,582
61,138
32,214
67,252
-
-
-
-
40,618
Total Revenue
$ 229,748
$ 240,923
$ 254,848
$ 260,840
$ 277,332
2286
Table A.1.b: Aggregated Lost Customer Revenue and Growth
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The following table shows how total customer attrition can be determined by aggregating historical
customer attrition and growth into one calculation. This allows the valuation specialist to project future
attrition and growth as a single input in a valuation analysis.
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The total revenue in each historical year from the customers’ existing in vintage year Time -5 is
determined for each subsequent year. The revenue losses, or growth, are determined for each historical
year.
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Aggregate Revenue Attrition
Revenue from Initial
Customers
Revenue Losses with
Attrition (as % of prior
year)
Geometric Average
Time -5
Time -4
Time -3
Time -2
Time -1
$ 229,748
$ 207,354
$ 191,381
$ 168,121
$ 137,247
-9.7%
-7.7%
-12.2%
-18.4%
= 1 - ( (137,247 / 229,748) ^
(1/4) )
= 12.1%
Arithmetic
Average
= 12.0%
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Note: “Revenue from Initial Customers” refers to total revenue received in each year from customers #1
through #17 shown in Table A.1.a.
2295
Table A.1.c: Forecast Using Historical Revenue Attrition – Aggregated Components
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2298
The above calculation can be used to forecast future attrition and revenue. Note that there is no separate
revenue growth added to the forecast. It is already included in the 12.1% attrition calculation as explained
above.
Prior Year Annual Revenue
(A)
Aggregate Revenue Attrition
(B)
Current Year Annual
Revenue
= A x ( 1 - B )
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
$ 277,330
$ 243,751
$ 214,238
$ 188,298
$ 165,499
$ 145,460
$ 127,848
12.1%
12.1%
12.1%
12.1%
12.1%
12.1%
12.1%
$ 243,751
$ 214,238
$ 188,298
$ 165,499
$ 145,460
$ 127,848
$ 112,368
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The example above assumes that the customer attrition behavior and the customer population
characteristics are calculated on the same basis in the forecast period as in the historical period. However,
the attrition rate utilized in Year 1 should consider additional factors such as material customer gains or
losses that might impact the projection of Year 1 revenue. For example, it may be appropriate for Year 1
revenues to reflect the current run-rate or projected Year 1 revenue and, as a result, the attrition rate
utilized in Year 1 may need to be adjusted.
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Tables A.1.d and A.1.e: Disaggregated Lost Customer Revenue and Growth
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Using the same data as outlined in Table A.1.a, the following tables show how total customer revenue
attrition can be determined by disaggregating customer revenue and growth. This allows the valuation
specialist to project future attrition and growth as two separate inputs in a valuation analysis. The
following table calculates the lost revenue without any growth.
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The lost revenue can be calculated using any base vintage year. In the following example, the attrition,
inclusive of revenue growth, is determined for the Time -5 vintage customer population. For example, the
Time -4 lost revenue of $23,741 represents the amount of Time -5 revenue lost from customers not
existing in year Time -4 (customer 6 [$9,256] plus customer 9 [$987] plus customer 16 [$13,498]). The
Time -3 lost revenue of $20,985 represents the amount of Time -5 revenue lost from customers not
existing in year Time -3 (customer 5 [$9,416] plus customer 10 [$11,569]). This lost revenue calculation
is determined in a similar manner for each year.
2317
A.1.d
Revenue Attrition - Lost Revenue
Time -5
Time -4
Time -3
Time -2
Time -1
$ 229,748
$ 206,007
$ 185,022
$ 159,126
$ 125,776
Total Revenue
Remaining from
Existing Customers
(Vintage Time -5)
Lost Revenue
N/A
23,741
20,985
25,896
33,350
Lost Revenue Attrition
= 23,741 /
229,748
= 20,985 /
229,748
= 25,896 /
229,748
= 33,350 /
229,748
= 10.3%
= 9.1%
= 11.3%
= 14.5%
Geometric Average
= 1 - ( (125,776 / 229,748) ^
(1/4) )
= 14.0%
Arithmetic
Average
= 11.3%
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The next step is the determination of historical revenue growth. The starting point for this analysis is the
determination of revenue in Time -5 from customers existing at the date of value (in this example defined
as Time -1 existing customers). The $125,776 represents the total revenue in year Time -5 from customers
that exist at Time -1 (customers 1, 4, 7, 8, 13, 14, 15, and 17). The revenue in each successive year is the
revenue remaining each year from this same customer group. From this revenue, annual growth and losses
can be determined. Note that the final revenue conclusion in this example at Time -1 of $137,247 is the
same as in the combined calculation above shown in Table A.1.b.
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A.1.e
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Revenue Attrition - Revenue Growth
Time -5
Time -4
Time -3
Time -2
Time -1
Revenue from
Retained Customers
$ 125,776
$ 128,564
$ 132,106
$ 134,112
$ 137,247
Revenue Growth
2.2%
2.8%
1.5%
2.3%
Geometric Average
= ( (137,247 / 125,776) ^
(1/4) ) - 1
= 2.2%
Arithmetic
Average
= 2.2%
2326
Table A.1.f: Forecast Using Historical Revenue Attrition – Disaggregated Components
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The above calculations shown in Tables A.1.d and A.1.e can be used to forecast future attrition. Note that
there are two separate inputs: one for lost revenue and one for revenue growth. In this example, please
note that the estimated revenue in each year matches the revenue shown in the aggregated example above
in Table A.1.c.
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Prior Year Annual Revenue
(A)
$ 277,330
$ 243,751
$ 214,238
$ 188,298
$ 165,499
$ 145,460
$ 127,848
Revenue Growth (B)
= 2.2%
= 2.2%
= 2.2%
= 2.2%
= 2.2%
= 2.2%
= 2.2%
Lost Revenue Attrition (C)
= 14.0%
= 14.0%
= 14.0%
= 14.0%
= 14.0%
= 14.0%
= 14.0%
Current Year Annual
Revenue
= A x ( 1 + B ) x
( 1 - C )
$ 243,751
$ 214,238
$ 188,298
$ 165,499
$ 145,460
$ 127,848
$ 112,368
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The example above assumes that the customer attrition behavior and the customer population
characteristics are calculated on the same basis in the forecast period as in the historical period. However,
the growth and attrition rates utilized in Year 1 should consider additional factors such as material
customer gains or losses that might impact the projection of Year 1 revenue. For example, it may be
appropriate for Year 1 revenues to reflect the current run-rate or projected Year 1 revenue and, as a result,
the growth and/or attrition rate utilized in Year 1 may need to be adjusted.
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Table A.1.g and A.1.h: Forecast Using Historical Customer Count
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The following table shows a similar approach to calculate attrition using customer count data versus
customer revenue data. The data used to calculate the attrition in the following table is from Table A.1.a.
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A.1.g
Customer Attrition
Time -5
Time -4
Time -3
Time -2
Time -1
Total Customers
Total Remaining
Existing Customers
(Vintage Time -5)
17
17
Customer Losses
N/A
Customer Loss
Attrition
15
14
3
14
12
2
13
11
1
11
8
3
= 3 / 17
= 2 / 17
= 1 / 17
= 3 / 17
= 17.6%
= 11.8%
= 5.9%
= 17.6%
Geometric Average
= 1 - ( (8 / 17) ^ (1/4) )
= 17.2%
Arithmetic
Average
= 13.2%
2341
The associated revenue forecast using the disaggregated attrition and growth is shown below.
2342
A.1.h
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Prior Year Annual Revenue
(A)
$ 277,330
$ 234,681
$ 198,591
$ 168,051
$ 142,208
$ 120,338
$ 101,832
Revenue Growth (B)
= 2.2%
= 2.2%
= 2.2%
= 2.2%
= 2.2%
= 2.2%
= 2.2%
Lost Revenue Attrition (C)
= 17.2%
= 17.2%
= 17.2%
= 17.2%
= 17.2%
= 17.2%
= 17.2%
Current Year Annual
Revenue
= A x ( 1 + B ) x
( 1 - C )
$ 234,681
$ 198,591
$ 168,051
$ 142,208
$ 120,338
$ 101,832
$ 86,172
The example above assumes that the customer attrition behavior and the customer population
characteristics are calculated on the same basis in the forecast period as in the historical period. However,
the growth and attrition rates utilized in Year 1 should consider additional factors such as material
customer gains or losses that might impact the projection of Year 1 revenue. For example, it may be
appropriate for Year 1 revenues to reflect the current run-rate or projected Year 1 revenue and, as a result,
the growth and/or attrition rate utilized in Year 1 may need to be adjusted.
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Example A.2: Statistical Techniques
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Using an analysis of historical customer count survival data, the following renewal probabilities and
expected survivor curve by survival age vintage year have been calculated. Developing a renewal
probability distribution by age vintage requires a large amount of quality data in order to estimate the
renewal probabilities by age vintage. It is possible to develop a similar analysis using management
estimates of renewal probabilities by age vintage.
2356
Table A.2.a: Renewal Probabilities by Age Vintage
Age
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
Renewal Probability % Expected Survivor Curve %
0%
70%
74%
78%
82%
86%
90%
90%
90%
90%
90%
90%
90%
90%
90%
90%
90%
90%
90%
90%
90%
100.0%
70.0%
51.8%
40.4%
33.1%
28.5%
25.6%
23.1%
20.8%
18.7%
16.8%
15.1%
13.6%
12.3%
11.0%
9.9%
8.9%
8.0%
7.2%
6.5%
5.9%
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Statistical analysis applied to the customer population data above can identify a survivor curve that
describes customer life expectancy. The Weibull distribution is one example that has historically been
used to describe life characteristics. There are many other statistical techniques and variations of the
Weibull distribution that can be applied to customer analysis and are outside the parameters of this
Valuation Advisory. However, this example is meant to demonstrate how statistical analyses may be used
in the valuation of customer relationships.
2363
The Weibull distribution is described mathematically as:
S(t) = e ^ -((t/a)^b) with t > 0
Where:
S (t) = survival percentage at time t
t = time or duration of the customer relationship
e = exponential function
a = scale parameter
b = shape parameter
Linear regression techniques are used to compare the expected renewal probability survivor curve with the
Weibull distribution survivor curve through a curve-fitting comparison process that solves for the shape
and scale parameters that are unique to the Weibull survivor curve that best fits the expected survival
curve. Alternatively, if spreadsheet software is unavailable, probability paper can be used to manually
develop the Weibull distribution curve with the best fit. In this example, it was determined that a scale
parameter (a) of 3.957 and a shape parameter of 0.643 created the Weibull curve with the best fit. Given
these scale and shape parameters, the Weibull percent survival curve percentages are compared to the
expected survival curve percentages from Table A.2.a above.
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Table A.2.b: Survival Curve Comparisons
Age
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
Renewal Probability % Expected Survivor Curve % Weibull Percent Surviving %
70%
74%
78%
82%
86%
90%
90%
90%
90%
90%
90%
90%
90%
90%
90%
90%
90%
90%
90%
90%
70.0%
51.8%
40.4%
33.1%
28.5%
25.6%
23.1%
20.8%
18.7%
16.8%
15.1%
13.6%
12.3%
11.0%
9.9%
8.9%
8.0%
7.2%
6.5%
5.9%
66.2%
52.5%
43.3%
36.5%
31.3%
27.1%
23.6%
20.8%
18.3%
16.3%
14.5%
13.0%
11.7%
10.5%
9.5%
8.6%
7.8%
7.1%
6.5%
5.9%
The above expected survival curve and Weibull percent surviving curves are plotted below to show the
curve fit.
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Chart A.2.a: Survival Curve Comparisons
80.0%
70.0%
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
Expected Survivor Curve %
Weibull Percent Surviving %
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
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The average life expectancy for the customer population is solved using the gamma function and the scale
and shape parameters from the Weibull distribution. Most spreadsheet software allows for the
computation using the gamma function:
2388
Life Expectancy = a * e ^ (gammaln (1 + (1/b))
2389
Life Expectancy = 5.5 years
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The average life expectancy is a key metric that defines a particular Weibull distribution. It does not
represent the life for the total customer population, as many customers will have lives beyond the
expectation of any given random customer.
2393
Example A.3: Management Estimates
Attrition analyses using management estimates generally take two forms: management’s estimation of
future attrition or management’s direct estimate of future revenues from the existing customer base. Care
should be taken using these methods to understand exactly what information management is including in
their forecast. For example, if management is providing attrition estimates, does the estimate include or
exclude expected revenue growth from the existing customer base? The following examples demonstrate
the calculation of an attrition rate using the two primary forms of management estimates: management’s
estimation of future attrition and management’s direct estimate of future revenues from the existing
customer base.
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Table A.3.a: Using Management Provided Revenue Attrition
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
$ 277,330
$ 242,803
$ 212,574
$ 186,108
$ 162,938
$ 142,652
$ 124,892
15.0%
15.0%
15.0%
15.0%
15.0%
15.0%
15.0%
3.0%
3.0%
3.0%
3.0%
3.0%
3.0%
3.0%
$ 242,803
$ 212,574
$ 186,108
$ 162,938
$ 142,652
$ 124,892
$ 109,343
Prior Year Annual Revenue
(A)
Attrition per Management
(B)
Growth in Sales from
Existing Base (C)
Current Year Annual
Revenue
= A x ( 1 – B )
x ( 1 + C )
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2400
2401
The example above assumes that the customer attrition behavior and the customer population
characteristics are calculated on the same basis in the forecast period as in the historical period. However,
the growth and attrition rates utilized in Year 1 should consider additional factors such as material
customer gains or losses that might impact the projection of Year 1 revenue. For example, it may be
appropriate for Year 1 revenues to reflect the current run-rate or projected Year 1 revenue and, as a result,
the growth and/or attrition rate utilized in Year 1 may need to be adjusted.
2402
Table A.3.b: Using Management Estimate of Total Revenues
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Total Revenue (A)
$ 285,650
$ 294,220
$ 303,047
$ 312,138
$ 321,502
$ 331,147
$ 341,082
Percentage from Existing
Base per Management (B)
Total Revenue from Existing
Base
= A x B
90.0%
80.0%
70.0%
60.0%
50.0%
40.0%
30.0%
$ 257,085
$ 235,376
$ 212,133
$ 187,283
$ 160,751
$ 132,459
$ 102,324
2403
2404
2405
2406
The valuation specialist may choose to perform certain assessments of the data provided by management.
For instance, what annual attrition rate is implied by the run-off of the existing base of customers? What is
the implied total market share gain in any given year indicated by the new customer additions projected by
management?
2407
Example A.4: Irregular Attrition Patterns
2408
2409
2410
2411
The valuation specialist should take care in measuring the rate of decay relating to the customer
relationships. Frequently, customer relationship attrition patterns demonstrate irregular patterns that are
not linear or do not demonstrate a “smooth” geometric pattern. In some cases, customer-related revenue,
and in turn cash flow, may initially increase before decreasing. In other cases, customer revenue, and in
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turn cash flow, may decline significantly before leveling off to a normalized rate. The table below presents
one baseline attrition scenario and two scenarios where attrition rates change over time. In each of these
scenarios, attrition rates are calculated based on historical customer data and are applied to future time
periods.
2416
Table A.4.a: Irregular Attrition Patterns
Attrition Rate By Year
Scenario 1 -
Base Case
Scenario 2 -
Growth Then
Decline
Scenario 3 -
Significant Decline
Then Stable
Year 1
Year 2
Year 3
Year 4
CAGR
-10.0%
-10.0%
-10.0%
-10.0%
-10.0%
20.0%
-20.0%
-20.0%
-20.0%
-11.5%
-50.0%
-10.0%
-10.0%
-10.0%
-22.3%
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2420
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2422
2423
Scenarios 1 and 3 are commonly used methods in applying historical customer data based attrition rates.
Scenario 2 shows negative attrition (or growth) from existing customers in the first projected year (in this
example, growth in Year 1 is intended to apply to all customers as of the valuation date as opposed to only
those customers added within the year prior to the valuation date). Growth in existing customers reflects
revenue growth since addition of new customers would not be included in the valuation of existing
customer relationships. The modeling of growth in existing customer revenue either as revenue growth or
as negative attrition should not result in a different value conclusion.
2424
2425
2426
The valuation specialist needs to adjust the calculated attrition rates to account for differing perspectives
between the data used to calculate the rate and where the data is applied. For instance, the attrition rate and
percent surviving for Scenario 1 could be viewed as follows:
2427
Table A.4.b: Percent Surviving Attrition Calculation – Scenario 1
Attrition Rate
Percent Surviving
Calculation
Year 1
-10.0%
90.0%
Prior year = 100.0%; current year = 90.0%
Year 2
-10.0%
81.0%
Prior year = 90.0%; current year = 81.0%
Year 3
-10.0%
72.9%
Prior year = 81.0%; current year = 72.9%
Year 4
-10.0%
65.6%
Prior year = 72.9%; current year = 65.6%
2428
2429
2430
2431
The percent surviving in Year 1 reflects the attrition rate of 10% because the data used in deriving the
attrition rate is determined based on an entire fiscal year. In the Working Group’s experience, customer
attrition statistics are calculated by comparing customer data over multiple fiscal years as opposed to
comparing customers that existed at the beginning of a fiscal year with those at the end of the fiscal year.
2432
The attrition rate and percent surviving for Scenario 2 could be viewed as follows:
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Table A.4.c: Percent Surviving Attrition Calculation - Scenario 2
Attrition Rate
Percent Surviving
Calculation
Year 1
20.0%
120.0%
Prior year = 100.0%; current year = 120.0%
Year 2
-20.0%
96.0%
Prior year = 120.0%; current year = 96.0%
Year 3
-20.0%
76.8%
Prior year = 96.0%; current year = 76.8%
Year 4
-20.0%
61.4%
Prior year = 76.8%; current year = 61.4%
2434
2435
Note: Year 1 percent surviving exceeds 100% due to expected growth in revenue from existing customers
exceeding expected attrition of existing customers during the first projected year.
2436
2437
2438
2439
The table above is reflective of a revenue-based attrition calculation because the application of negative
attrition using a customer count-based attrition rate would be reflective of new customer additions. The
value associated with new customer additions is not included in the value associated with existing
customer-related assets.
2440
The attrition rate and percent surviving for Scenario 3 could be viewed as follows:
2441
Table A.4.d: Percent Surviving Attrition Calculation - Scenario 3
Attrition Rate
Percent Surviving
Calculation
Year 1
-50.0%
50.0%
Prior year = 100.0%; current year = 50.0%
Year 2
-10.0%
45.0%
Prior year = 50.0%; current year = 45.0%
Year 3
-10.0%
40.5%
Prior year = 45.0%; current year = 40.5%
Year 4
-10.0%
36.5%
Prior year = 40.5%; current year = 36.5%
2442
Example A.5: Partial Period and Mid-Year Convention Issues Related to Attrition
2443
2444
2445
2446
2447
Care should be taken in applying an attrition rate to partial periods. Table A.5.a below provides an
example of estimated attrition rates and percent surviving for a scenario where the attrition rate is
estimated to be 10% and there is no adjustment needed for a partial period in year 1. Table A.5.b below
shows the percent surviving calculations assuming that year 1 of the forecast is a partial period with 25%
of year 1 cash flows used to value the customer relationships.
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Table A.5.a: Percent Surviving Assuming No Partial Period
Scenario 1 - No Partial Period
Annualized
Attrition
Rate
( A )
Average Percent
Surviving - Prior
Year ( B )
Average Percent
Surviving -
Current Year
C = B * ( 1 - A )
Year 1
Year 2
Year 3
10.0%
10.0%
10.0%
100.0%
90.0%
81.0%
90.0%
81.0%
72.9%
2449
Table A.5.b: Percent Surviving Assuming Partial Period Adjustment
Scenario 2 - Partial Period when 25% of Fiscal Year 1 remains (75% of the fiscal year is complete)
Annualized Attrition
Rate
( A )
Partial Period
Percentage
( B )
Average Percent
Surviving - Prior
Year
( C )
Average Percent
Surviving - Current
Year
D = C * (1 - B * A )
Year 1
Year 2
Year 3
10.0%
10.0%
10.0%
25.0%
100.0%
100.0%
100.0%
97.5%
87.8%
97.5%
87.8%
79.0%
2450
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2452
The Working Group believes that the above attrition calculations represent average annual loss. The
notion of average losses is already captured in the attrition calculation and any adjustments related to a
partial period are only necessary to fit the selected attrition curve to the appropriate time period.
It should also be noted that the analysis in this section is based on the latest fiscal year and/or current
fiscal year revenue that are consistent with market participant PFI. If the base revenue used in the
customer analysis is adjusted to reflect significant gains or losses in revenue over the prior period, the
attrition rate will also need to be adjusted because it will no longer need to reflect the average annual loss.
2453
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2455
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2458
APPENDIX B: CASE STUDY EXAMPLES
2459
2460
2461
2462
2463
2464
2465
The following examples were developed to illustrate a set of facts and circumstances and the related
valuation of the customer relationship asset. Professional judgment must be utilized in the valuation
process. Additionally, as the case studies are simplified examples, in practice a full analysis would be
substantially more robust and would include the valuation of other assets and liabilities, supporting
exhibits, and a comprehensive narrative. The Working Group notes that the application of attrition in the
following case studies is meant to be illustrative and, as outlined previously in this Valuation Advisory, is
not intended to represent the only acceptable applications.
2466
The following assumptions relate to each of the examples:
2467
2468
2469
2470
2471
2472
2473
2474
a. As a simplifying assumption, depreciation is considered to be a reasonable estimate of the return
of capital related to fixed assets.
b. The determination of contributory asset charges is consistent with the methodology in the VFR
Valuation Advisory #1. In some cases, practical expedients outlined in the VFR Valuation
Advisory #1 are used. For instance, in these examples, the Working Group notes that the mid-
period adjustment to CACs is not applied for practical expediency purposes.
c. Certain inputs, such as the Return on Working Capital, normally have supporting calculations.
These calculations are outside the scope of this document.
2475
Example B.1: Consumer Branded Product Company
2476
Transaction
2477
2478
2479
On December 31, 2015, AcquireCo purchased TargetCo for a purchase consideration of $500 million in
cash in a stock deal. The transaction was competitive with two additional companies interested in
purchasing TargetCo.
2480
AcquireCo’s rationale for undertaking the transaction included the following:
2481
2482
2483
2484
2485
a. Immediate entry into TargetCo’s markets.
b. TargetCo’s portfolio of regionally dominant brands.
c. Significant cost synergies.
d. The ability to sell TargetCo’s brands in adjacent regions.
e. Prevent AcquireCo’s competitors from obtaining TargetCo’s brands and market dominance.
2486
Acquirer Profile
2487
2488
2489
2490
2491
2492
AcquireCo is a publicly-held multi-national food and beverage producer. Its strategy is to maintain a
portfolio of strong brands catering to various segments of the market. The brands are typically
longstanding brands with strong market share and superior brand equity in their respective markets and
regions. Some brands were developed in-house over a period of many decades while others are long-
standing brands that were acquired. In recent years, the company has refocused its strategy and exited
non-core areas.
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Target Description
2494
2495
2496
2497
TargetCo is a leading producer of branded snack products in the Southeast. Founded in 1905, its brands
have achieved near iconic status and virtually all consumers in its region are familiar with them. TargetCo
is headquartered in Atlanta and conducts business in the surrounding region. The company differentiates
itself by producing fresh products using high-quality ingredients.
2498
Assets Acquired
2499
2500
2501
Assets acquired as a part of the transaction included working capital and fixed and intangible assets. Fixed
assets consisted largely of machinery. Intangible assets consisted of trademarks and related recipes
(collectively referred to as brands) and customer relationships.
2502
Customer Characteristics
2503
2504
2505
2506
2507
2508
2509
Customers consist of wholesalers and retailers of the company’s products. While the wholesalers and
retailers enable TargetCo to reach its end (consumers) customers, they are not a key business driver. The
key driver of revenue is consumer demand for the product. The strength of this consumer demand is
witnessed in a recent event. One retailer, a supermarket, decided to stop carrying the brands after a
disagreement over pricing. Two days later, the supermarket decided to resume selling TargetCo brands as
those sales had largely been lost rather than transitioned to other brands and private label products as
expected.
2510
2511
2512
2513
2514
An analysis of historical customer sales indicated annual customer attrition of approximately 7.6% and
annual revenue attrition (due to loss of customers) of approximately 4.1% (based on geometric average
calculations). Based on the expectation that historical results are indicative of future attrition, the
estimated attrition rate is 5.0%. Revenue growth of retained customers is expected to be approximately 1%
per year.
2515
Facts and Circumstances Leading to the Methodology Selection
2516
2517
2518
2519
2520
2521
Based on discussions with management, it was determined that there are two intangible assets present:
brands and customer relationships. The brands were determined to be the company’s primary asset. The
brands have dominant positions and strong brand equity. The retailer carries the brand based on the
knowledge that there is significant customer demand. As such, the relationships with the wholesaler or
retailer enable the company to reach the consumer but are not primary drivers of the consumer purchasing
decision.
2522
2523
2524
Based on the factors above, the valuation specialist determined that the MPEEM was most appropriately
used to value the brands and the Distributor Model was most appropriate to value the customer
relationships.
2525
2526
2527
2528
2529
2530
The rationale for the selected method is that the customer-related activities and the value added by those
activities are similar for the entity and distributors. TargetCo and distributors maintain end customer
relationships by providing the desired product in a cost effective and timely manner. As such, distributors,
which have economic characteristics that are representative of the relationship between the company and
its customers, were chosen to serve as a proxy for the valuation of the customer-related assets. In
particular, the selected companies distribute food products to various retail establishments including
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grocery, discount, and convenience stores. The operating margin is believed indicative of the margin
earned by the customer relationship function and the contributory asset charges reflect the assets required
to service the distribution function.
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Table B.1: Consumer Branded Product Company
Revenue at Acquisition
Revenue Adjusted for Growth
Remaining After Attrition
Revenue After Attrition
EBITA
Less: Income Taxes
Debt Free Net Income
Debt Free Net Income Margin
Returns on Contributory Assets
Normal Working Capital
Property, Plant & Equipment
Workforce
Return on Contributory Assets
% of Revenue
(1)
(1)
(2)
(3)
(4)
(4)
(4)
Net After Tax Cash Flow to Customer Relationships
Partial Period Adjustment
Period
Discount Factor
PV of Cash Flow
PV of Cash Flows
Tax Benefit=L/(L-(Fa*T))
Tax Life
Tax Rate
Discount Rate
Annuity Factor
Mid-Year Adj Factor
Tax Benefit
Fair Value
Fair Value (Rounded)
Assumptions
Growth of Retained Customers
Attrition
EBITA Margin
Tax Rate
WC to Revenue Ratio
Return on WC
PP&E to Revenue Ratio
Return on PP&E
Assembled Workforce CAC
Discount Rate
2535
Notes:
15 Years
40.0%
15.0%
5.8474
1.0724
20.1%
(5)
(6)
(2)
(3)
(4)
(4)
(4)
(4)
(4)
(5)
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
357,081
360,652
364,259
367,901
371,580
375,296
95.0%
342,619
90.3%
328,743
85.7%
315,429
81.5%
302,654
77.4%
290,397
14,047
(5,619)
8,428
2.5%
(2,467)
(857)
(343)
(3,666)
-1.1%
4,762
1.000
0.500
0.933
4,441
13,478
(5,391)
8,087
2.5%
(2,367)
(822)
(329)
(3,518)
-1.1%
4,570
1.000
1.500
0.811
3,705
12,933
(5,173)
7,760
2.5%
(2,271)
(789)
(315)
(3,375)
-1.1%
4,384
1.000
2.500
0.705
3,092
12,409
(4,964)
7,445
2.5%
(2,179)
(757)
(303)
(3,238)
-1.1%
4,207
1.000
3.500
0.613
2,579
11,906
(4,763)
7,144
2.5%
(2,091)
(726)
(290)
(3,107)
-1.1%
4,037
1.000
4.500
0.533
2,152
26,092
5,239
31,332
31,000
1.0%
5.0%
4.1%
40.0%
9.0%
8.0%
2.5%
10.0%
0.1%
15.0%
Year 1
1.0%
5.0%
4.1%
40.0%
9.0%
8.0%
2.5%
10.0%
0.1%
Year 2
1.0%
5.0%
4.1%
40.0%
9.0%
8.0%
2.5%
10.0%
0.1%
Year 3
1.0%
5.0%
4.1%
40.0%
9.0%
8.0%
2.5%
10.0%
0.1%
Year 4
1.0%
5.0%
4.1%
40.0%
9.0%
8.0%
2.5%
10.0%
0.1%
Year 5
1.0%
5.0%
4.1%
40.0%
9.0%
8.0%
2.5%
10.0%
0.1%
2536
(1) Revenue at acquisition is based on last fiscal year results. Forecasts reflect market participant PFI.
2537
(2) Attrition is based on the historical attrition analysis.
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2540
2541
2542
2543
2544
2545
2546
2547
2548
2549
2550
(3) EBITA margin is based on observed margins for distributors that have economic characteristics
that are representative of the relationship between the subject company and its customers
(“comparable distributors”).
(4) The fixed asset and working capital levels are based on observable market inputs for comparable
distributors. The workforce CAC is based on the value of the workforce. The workforce was
valued based on its cost to re-create. A low workforce CAC is consistent with the expectation that
a distributor would achieve significant revenue per employee.
(5) The selected discount rate is based on the valuation specialist’s assessment of risk. Though not
displayed, it is assumed the discount rate is reasonable when viewed within the context of the
overall analysis.
(6) The customer relationship asset was valued over its 20-year life. Five years are shown for display
purposes. For purposes of this example, no material customer relationship value was assumed to
exist after year 20.
2551
Testing Outputs
2552
2553
2554
2555
2556
As part of a standard customer relationship valuation, it is important that valuation specialists test the
outputs of their analysis. The Working Group believes that this is a critical step that needs to occur in
order for the valuation to be considered complete. The following paragraph is an example of some of the
elements that can be addressed as it pertains to the case study. It exists as an illustration of a simple
example; application in a valuation engagement would likely need to be more robust.
2557
2558
2559
2560
2561
2562
2563
The value of the customer relationships was estimated to be $31 million or approximately 6.2% of the
total purchase consideration. Additionally, when valuing the customer relationships, the cash flow
attributed to the customer relationships is a small portion of the total margin. This is reasonable given the
following factors: the customers are highly transactional and driven by a need to provide consumers with
the desired product; the brands owned by the company are the key driver of sales and were the primary
acquisition rationale; and they are iconic in their region and consumers seek out retailers that carry the
brands.
2564
Example B.2: Defense Company
2565
Transaction
2566
2567
2568
2569
On December 31, 2015, AcquireCo purchased TargetCo for a purchase consideration of $85 million in
cash in a stock deal. AcquireCo approached TargetCo with an offer. While the transaction was not
competitive, investment bankers reached out to other potential acquirers. The transaction occurred at a
multiple that appears in-line with other transactions within the industry.
2570
AcquireCo’s rationale for undertaking the transaction included the following:
2571
2572
2573
2574
a. TargetCo has approximately 15 long-standing relationships with agencies and departments within
the US military and defense communities.
b. TargetCo has a highly qualified workforce consisting of engineers and programmers, most of
whom have security clearances.
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Acquirer Profile
2576
2577
2578
2579
AcquireCo is a mid-cap publicly traded defense firm. It provides information technology, information
systems, systems integration, and related engineering services to the military and intelligence
communities. It enters into multi-year contracts that often have multiple potential extensions. AcquireCo
was founded 30 years ago and is headquartered in Falls Church, Virginia.
2580
Target Description
2581
2582
2583
2584
TargetCo is a provider of information technology and related services to certain intelligence-related
agencies and offices. The company was founded 15 years ago by a former intelligence officer and has
achieved rapid growth since its founding. It currently has nearly 30 customers, approximately half of
whom have been customers for at least five years. TargetCo is located in Fairfax, Virginia.
2585
Assets Acquired
2586
2587
2588
2589
Assets acquired as a part of the transaction included working capital, fixed and intangible assets. Fixed
assets were minimal and consisted mainly of furniture and computers. The only identifiable intangible
acquired was customer relationships. Another key acquisition rationale, the assembled workforce, is not a
recognized intangible asset.
2590
Customer Characteristics
2591
2592
2593
2594
2595
2596
2597
TargetCo enters into multi-year contracts with customers. These contracts may be cost-plus, time-and-
materials, or firm fixed price. The company earns margins that are higher than typically observed among
its competitors. There are several factors driving the higher margins. First, the company has a higher
portion of contracts that are fixed price than most market participants. Since these contracts offer a fixed
price for the service performed, they are higher risk but also potentially higher margin. Additionally,
TargetCo performs primarily high-end work. While publicly traded market participants are sufficiently
large that they have both high- and low-margin contracts, TargetCo has limited low-margin contracts.
2598
2599
2600
2601
2602
2603
A five-year revenue forecast was provided on a customer-by-customer basis. Management estimated the
revenue by customer by adjusting for expected pricing and contract renewals. Low attrition has been
experienced previously and is expected in the future. Long-standing relationships between multiple
individuals at TargetCo and its customers, as well as engineers who are “embedded” at customer sites,
lead to strong retention rates. While all contracts and extensions are cost competitive, management
indicates they are typically the preferred provider.
2604
Facts and Circumstances Leading to the Methodology Selection
2605
2606
2607
2608
2609
Based on discussions with management, it was determined that the only identifiable intangible asset
present is the customer relationship asset. As the unique asset, the value of the customer relationship asset
was estimated utilizing the MPEEM. Company specific inputs were utilized as the above average margins
reflect the profitability of the contracts and relationships in place. A market participant would obtain the
same level of profitability from these relationships.
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Table B.2: Defense Company
Revenue After Attrition
EBITA
Adjustments
Sales & Marketing Add-Back
Adjusted EBITA
Less: Income Taxes
Debt Free Net Income
Debt Free Net Income Margin
Returns on Contributory Assets
Normal Working Capital
Property, Plant & Equipment
Workforce
Return on Contributory Assets
% of Revenue
(1)
(2)
(3)
(4)
(4)
(5)
Net After Tax Cash Flow to Customer Relationships
Partial Period Adjustment
Period
Discount Factor
PV of Cash Flow
PV of Cash Flows
Tax Benefit=L/(L-(Fa*T))
Tax Life
Tax Rate
Discount Rate
Annuity Factor
Mid-Year Adj Factor
Tax Benefit
Fair Value
Fair Value (Rounded)
Assumptions
EBITA Margin
Sales & Marketing Add-Back
Tax Rate
WC to Revenue Ratio
Return on WC
PP&E to Revenue Ratio
Return on PP&E
Assembled Workforce CAC
Discount Rate
15 Years
40.0%
15.0%
5.8474
1.0724
20.1%
(6)
(7)
(2)
(3)
(4)
(4)
(4)
(4)
(5)
(6)
18,814
3,778
22,592
23,000
12.0%
1.0%
40.0%
15.0%
8.0%
1.5%
10.0%
3.0%
15.0%
Year 1
Year 2
Year 3
Year 4
Year 5
100,000
99,132
95,532
86,679
85,985
12,000
11,896
11,464
10,402
10,318
1,000
13,000
(5,200)
7,800
7.8%
(1,200)
(150)
(3,000)
(4,350)
-4.4%
3,450
1.000
0.500
0.933
3,217
991
12,887
(5,155)
7,732
7.8%
(1,190)
(149)
(2,974)
(4,312)
-4.4%
3,420
1.000
1.500
0.811
2,773
955
12,419
(4,968)
7,452
7.8%
(1,146)
(143)
(2,866)
(4,156)
-4.4%
3,296
1.000
2.500
0.705
2,324
867
11,268
(4,507)
6,761
7.8%
(1,040)
(130)
(2,600)
(3,771)
-4.4%
2,990
1.000
3.500
0.613
1,834
860
11,178
(4,471)
6,707
7.8%
(1,032)
(129)
(2,580)
(3,740)
-4.4%
2,966
1.000
4.500
0.533
1,582
Year 1
12.0%
1.0%
40.0%
15.0%
8.0%
1.5%
10.0%
3.0%
Year 2
12.0%
1.0%
40.0%
15.0%
8.0%
1.5%
10.0%
3.0%
Year 3
12.0%
1.0%
40.0%
15.0%
8.0%
1.5%
10.0%
3.0%
Year 4
12.0%
1.0%
40.0%
15.0%
8.0%
1.5%
10.0%
3.0%
Year 5
12.0%
1.0%
40.0%
15.0%
8.0%
1.5%
10.0%
3.0%
2611
2612
2613
2614
Notes:
(1) Year 1 revenue reflects expected full-year results as of the valuation date.
(2) The margin is based on the projected margin. It is believed to be representative of the margin
market participants would earn through use of the customer relationship asset.
2615
(3) Sales and marketing expenses related to the addition of new customers were added back.
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2618
2619
2620
2621
2622
2623
2624
2625
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2627
2628
2629
2630
(4) The fixed asset and working capital levels are based on historical levels and assumed to be
consistent with market participant expectations for future levels.
(5) The workforce CAC is based on the value of the workforce. The workforce was valued based on
its cost to re-create. A significant workforce CAC is viewed as reasonable. The workforce is highly
sophisticated and substantial time and effort would be required to reassemble it. The VFR
Valuation Advisory #1 outlines potential adjustments to the valuation related to the workforce,
such as an addback of expenditures related to growth of the workforce and the addition of a
hypothetical tax benefit from amortization of the workforce asset. Consistent with the practical
expedient methodology in the VFR Valuation Advisory #1, these adjustments have not been
included in this example.
(6) The selected discount rate is based on the valuation specialist’s assessment of risk. Though not
displayed, it is assumed the discount rate is reasonable when viewed within the context of the
overall analysis.
(7) The customer relationship asset was valued over its 20-year economic life. Five years are shown
for display purposes.
2631
Testing Outputs
2632
2633
2634
2635
2636
2637
2638
2639
The value of the customer relationships was estimated to be $23 million or approximately 27.1% of the
total purchase consideration. Additionally, the cash flow margin attributed to the customer relationships is
approximately half of the tax affected EBITA margin. This is reasonable given the following factors: the
customer relationships, in conjunction with the workforce, were the primary acquisition rationale; and, the
company has multi-year contracts with government agencies. Additionally, due to the skill set of its
workers and its understanding of customer needs, it has a strong track record of winning contract
extensions. Externally, the importance of the customer relationships is emphasized in that the company
publishes a press release when it wins significant contracts.
2640
Example B.3: Packaging Solutions Provider
2641
Transaction
2642
2643
2644
On September 30, 2015, FinancialBuyer partnered with key members of management to undertake a
management buyout of TargetCo. The purchase consideration was $200 million and the transaction was
structured as a stock purchase. The transaction was competitive with multiple financial buyers bidding.
2645
FinancialBuyer’s rationale for undertaking the transaction included the following:
2646
2647
2648
2649
2650
2651
a. FinancialBuyer co-invests with management in well-run, mid-size companies.
b. TargetCo is the leading packaging solutions provider in its region.
c. The company is well known and respected within its market niche. Its reputation for high-quality
products and timely service drives strong sales.
d. The company’s customers are highly recurring and stable. They are recurring due to high-quality
products provided in a timely and cost-effective manner.
2652
Acquirer Profile
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
© 2016 The Appraisal Foundation
105
2653
2654
2655
2656
FinancialBuyer is a private equity firm investing in family- and management-owned businesses. It
typically co-invests with management in mid-sized specialty firms that operate in defensible niches having
high barriers to entry. It seeks to acquire strong operating companies with management that have
demonstrated a commitment to growth and profitability.
2657
Target Description
2658
2659
2660
2661
2662
TargetCo is a leading provider of packaging solutions in its region. Founded 28 years ago, it has highly
recurring relationships with a variety of companies that utilize its packaging solutions. The company has
several national competitors and one regional competitor. Due to the scale necessary to operate profitably,
competition from new entrants is considered unlikely. The company is highly regarded in its market niche
for providing high-quality products in a timely and cost-effective manner.
2663
Assets Acquired
2664
2665
2666
2667
Assets acquired as a part of the transaction included fixed and intangible assets. Fixed assets consist
largely of machinery and working capital. Intangible assets consist largely of customer relationships and
the corporate trade name. Additionally, there is an assembled workforce and limited proprietary
technology.
2668
Customer Characteristics
2669
2670
2671
2672
2673
2674
Customers consist of a variety of companies which utilize TargetCo’s packaging solutions. The customers
have historically been highly recurring. The recurring nature of the customers is based on the quality of
products and service provided. Management believes that were the company to deliver lower quality
service or raise prices significantly, customers would be lost to competitors. The company is a preferred
provider to its customer base and though customers have several choices for their packaging needs, they
prefer to utilize TargetCo.
2675
2676
2677
2678
2679
An analysis of historical customer sales indicated average customer attrition of approximately 6.8% and
revenue attrition of approximately 4.5%. Observations indicate that customer behavior, regardless of
customer size, is similar across the customer population. Based on the expectation that historical results
are indicative of future attrition, the estimated attrition rate is 5.0%. Revenue growth of retained customers
is expected to be approximately 1% per year.
2680
Facts and Circumstances Leading to the Methodology Selection
2681
2682
2683
2684
2685
2686
Based on discussions with management, it was determined that there are four intangible assets present:
backlog, customer relationships, the corporate trade name, and proprietary technology. Backlog and
customer relationships are the primary assets and the corporate name and proprietary technology are
contributory assets. As such, the MPEEM was utilized to value the backlog and customer relationships
and contributory asset charges were taken for use of the working capital, fixed assets, corporate trade
name, and proprietary technology.
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
© 2016 The Appraisal Foundation
106
2687
Table B.3-a: Packaging Solutions Provider (Backlog)
Backlog at Acquisition
Probability of Cancellation
Revenue After Attrition
EBITA
Pretax Returns on Contributory Assets
Trademark
Technology
Adjusted EBITA
Less: Income Taxes
Debt Free Net Income
Debt Free Net Income Margin
Returns on Contributory Assets
Normal Working Capital
Property, Plant & Equipment
Workforce
Return on Contributory Assets
% of Revenue
Net After Tax Cash Flow to Backlog
Period
Discount Factor
PV of Cash Flow
PV of Cash Flows
Tax Benefit=L/(L-(Fa*T))
Tax Life
Tax Rate
Discount Rate
Annuity Factor
Mid-Year Adj Factor
Tax Benefit
Fair Value
Fair Value (Rounded)
Assumptions
Growth of Retained Customers
Attrition
EBITA Margin
Royalty Rate - Trademark
Royalty Rate - Technology
Tax Rate
WC to Revenue Ratio
Return on WC
PP&E to Revenue Ratio
Return on PP&E
Assembled Workforce CAC
Discount Rate
2688
(1)
(2)
(3)
(4)
(4)
(5)
(5)
(5)
(7)
(2)
(2)
(3)
(4)
(4)
(5)
(5)
(5)
(5)
(5)
(7)
Year 1
20,000
0.0%
20,000
3,860
(400)
(100)
3,360
(1,344)
2,016
10.1%
(240)
(400)
(100)
(740)
-3.7%
1,276
0.125
0.983
1,254
15 Years
40.0%
15.0%
5.8474
1.0724
20.1%
1,254
252
1,506
1,500
Year 1
Ongoing
Assumptions
Backlog
Assumptions
1.0%
5.0%
14.3%
2.0%
0.5%
40.0%
15.0%
8.0%
20.0%
10.0%
0.5%
15.0%
1.0%
5.0%
19.3%
2.0%
0.5%
40.0%
15.0%
8.0%
20.0%
10.0%
0.5%
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
© 2016 The Appraisal Foundation
107
Notes: See Table B.3-b.
2689
Table B.3-b: Packaging Solutions Provider (Customer Relationships)
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
© 2016 The Appraisal Foundation
108
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
247,525
250,000
252,500
255,025
257,575
260,151
(20,000)
230,000
252,500
255,025
257,575
260,151
98.8%
227,125
93.8%
236,877
89.1%
227,283
84.7%
218,078
80.4%
209,246
32,479
33,873
32,501
31,185
29,922
(4,543)
(1,136)
26,801
(10,720)
16,080
7.1%
(2,726)
(4,543)
(1,136)
(8,404)
-3.7%
7,677
0.250
0.125
0.983
1,886
Year 1
1.0%
5.0%
(4,738)
(1,184)
27,951
(11,181)
16,771
7.1%
(2,843)
(4,738)
(1,184)
(8,764)
-3.7%
8,006
1.000
0.750
0.900
7,210
(4,546)
(1,136)
26,819
(10,728)
16,092
7.1%
(2,727)
(4,546)
(1,136)
(8,409)
-3.7%
7,682
1.000
1.750
0.783
6,015
(4,362)
(1,090)
25,733
(10,293)
15,440
7.1%
(2,617)
(4,362)
(1,090)
(8,069)
-3.7%
7,371
1.000
2.750
0.681
5,019
(4,185)
(1,046)
24,691
(9,876)
14,815
7.1%
(2,511)
(4,185)
(1,046)
(7,742)
-3.7%
7,073
1.000
3.750
0.592
4,188
Year 2
1.0%
5.0%
14.3%
2.0%
0.5%
40.0%
15.0%
8.0%
20.0%
10.0%
0.5%
Year 3
1.0%
5.0%
14.3%
2.0%
0.5%
40.0%
15.0%
8.0%
20.0%
10.0%
0.5%
Year 4
1.0%
5.0%
14.3%
2.0%
0.5%
40.0%
15.0%
8.0%
20.0%
10.0%
0.5%
Year 5
1.0%
5.0%
14.3%
2.0%
0.5%
40.0%
15.0%
8.0%
20.0%
10.0%
0.5%
Revenue at Acquisition
Revenue Adjusted for Growth
Less: Backlog
Revenue Adjusted for Backlog
Remaining After Attrition
Revenue After Attrition
EBITA
Pretax Returns on Contributory Assets
Trademark
Technology
Adjusted EBITA
Less: Income Taxes
Debt Free Net Income
Debt Free Net Income Margin
Returns on Contributory Assets
Normal Working Capital
Property, Plant & Equipment
Workforce
Return on Contributory Assets
% of Revenue
(1)
(1)
(2)
(3)
(4)
(4)
(5)
(5)
(5)
Net After Tax Cash Flow to Customer Relationships
Partial Period Adjustment
Period
Discount Factor
PV of Cash Flow
PV of Cash Flows
Tax Benefit=L/(L-(Fa*T))
Tax Life
Tax Rate
Discount Rate
Annuity Factor
Mid-Year Adj Factor
Tax Benefit
Fair Value
Fair Value (Rounded)
Assumptions
Growth of Retained Customers
Annualized Attrition
(6)
(7)
(8)
(2)
(2)
15 Years
40.0%
15.0%
5.8474
1.0724
20.1%
44,015
8,838
52,853
53,000
1.0%
5.0%
Calculation of Year 1 Attrition: Annualized attrition multiplied by partial period factor ( = 5.0% * 0.25)
EBITA Margin
Royalty Rate - Trademark
Royalty Rate - Technology
Tax Rate
WC to Revenue Ratio
Return on WC
PP&E to Revenue Ratio
Return on PP&E
Assembled Workforce CAC
Discount Rate
(3)
(4)
(4)
(5)
(5)
(5)
(5)
(5)
(7)
14.3%
2.0%
0.5%
40.0%
15.0%
8.0%
20.0%
10.0%
0.5%
15.0%
14.3%
2.0%
0.5%
40.0%
15.0%
8.0%
20.0%
10.0%
0.5%
2690
2691
Notes:
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
© 2016 The Appraisal Foundation
109
2692
(1) Initial revenue is based on the market participant PFI, adjusted for backlog.
2693
2694
2695
2696
2697
2698
2699
2700
2701
2702
2703
2704
2705
2706
(2) Attrition is based on the historical attrition analysis. Backlog is assumed to have realization
probability of 100%.
(3) The margin is based on the market participant PFI for existing customers (i.e., inclusive of
appropriate adjustments for expenses associated with new customer acquisition). For backlog, the
margin has been adjusted to add back certain sales and marketing costs that have already been
incurred (in this example, assumed to be 5% of revenue).
(4) The corporate trade name and the proprietary technology were valued utilizing the relief from
royalty approach and the royalty rate was used as the pre-tax CAC. The selected royalty rate
reflects the relative importance of the intangible asset to the business and market transaction data
obtained from a third-party source.
(5) The fixed asset and working capital levels are based on the company’s historical and expected
fixed asset and working capital requirements. Additionally, they appear reasonable when viewed
relative to comparable companies. The workforce charge is based on the value of the workforce.
The workforce was valued based on its cost to re-create.
2707
(6) The partial period assumes the first period is one quarter of a year.
2708
2709
2710
2711
2712
(7) The selected discount rate is based on the valuation specialist’s assessment of risk. Though not
displayed, it is assumed the discount rate is reasonable when viewed within the context of the
overall analysis.
(8) The customer relationship asset was valued over its 20-year life. Five years are shown for display
purposes.
2713
Testing Outputs
2714
2715
2716
2717
2718
2719
2720
The value of the backlog and customer relationships was estimated to be $54.5 million or approximately
27% of the total purchase consideration. Additionally, the cash flow margin attributed to the customer
relationships is approximately 40% of the tax affected EBITA margin. This is reasonable given the
following factors: (1) the customer relationships were a primary acquisition rationale; (2) customers are
highly recurring and it has taken a number of years for the company to develop the level of relationships it
has in place; and (3) though the market is highly cost competitive, customers prefer to use the TargetCo as
their packaging provider.
2721
Example B.4: Hardware Company
2722
Transaction
2723
2724
2725
On January 1, 2011, TechCo purchased TargetTechCo for a purchase consideration of $2.1 billion and the
transaction was structured as a stock purchase. The transaction was competitive with multiple strategic
buyers bidding.
2726
TechCo’s rationale for undertaking the transaction included the following:
2727
a. Strong existing technology platform.
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
© 2016 The Appraisal Foundation
110
2728
2729
2730
b. Strong development pipeline of new projects.
c. Ongoing and recurring purchases of components by manufacturers integrating them into larger
systems.
2731
Acquirer Profile
2732
2733
2734
2735
TechCo is a publicly traded technology company that focuses on developing hardware and software
products. They are considered by many to be one of the largest market participants in their industry
segment and have traditionally made acquisitions a large part of their growth strategy. Acquisitions are
considered by TechCo management as a necessary way to accelerate their technology roadmap.
2736
Target Description
2737
2738
2739
2740
2741
2742
TargetTechCo is a leading provider of hardware components that other manufacturers integrate into
assembled systems. They spend a significant amount each year on research and development and their
management philosophy has always been to develop state-of-the-art technologies that would “speak for
themselves” in the marketplace. They, unfortunately, have spent too little on sales and marketing and,
consequently, sales have dropped in recent years, even though many of their competitors agree that they
develop a high-quality solution.
2743
Assets Acquired
2744
2745
2746
Assets acquired as a part of the transaction included fixed and intangible assets. Fixed assets are relatively
immaterial to the total purchase consideration. Intangible assets consist largely of technology, in-process
research and development, and customer relationships.
2747
Customer Characteristics
2748
2749
2750
2751
Customers consist of a variety of companies that utilize TargetTechCo’s hardware components. While
market participants would likely also expect to leverage the acquired business’s established customer
relationships to sell existing and new products, the continuation of the customer relationships is largely
dependent on the technological capabilities offered by the business’s products.
2752
Facts and Circumstances Leading to the Methodology Selection
2753
2754
2755
2756
2757
2758
2759
2760
Based on discussions with management, it was determined that there are three intangible assets present:
customer relationships, existing technology, and in-process research and development. Technology and in-
process research and development were the primary assets identified. Customer relationships were
determined to be a secondary asset. As such, the MPEEM was utilized to value the technology and in-
process research and development. A with-and-without model was used to value the customer
relationships. Based on discussions with management, it was determined that the customer relationship
could be re-created in three years. Please note, however, that the useful life of the asset was determined to
be six years based on an analysis of historical customer attrition rates.
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
© 2016 The Appraisal Foundation
111
2761
Table B.4.a: Hardware Company With Approach
2010
2011
2012
2013
Revenue With Existing Customers
Less: Cost of Goods Sold
Gross Profit
$
600.0
(300.0)
300.0
$
750.0
(375.0)
375.0
$
1,000.0
(500.0)
500.0
$
1,200.0
(600.0)
600.0
(72.0)
(48.0)
-
180.0
(72.0)
108.0
(90.0)
(60.0)
-
225.0
(90.0)
135.0
(120.0)
(80.0)
-
300.0
(120.0)
180.0
(144.0)
(96.0)
-
360.0
(144.0)
216.0
37.5
(6.0)
(37.5)
129.0
$
50.0
(10.0)
(50.0)
170.0
$
60.0
(8.0)
(60.0)
208.0
$
0.5
1.5
2.5
0.9325
120.3
$
0.8109
137.8
$
0.7051
146.7
$
See schedule on next page.
$
404.8
290.5
114.3
23.0
$
137.3
Less: Fixed Operating Expenses
Less: Variable Operating Expenses
Less: Incremental "Re-Creation" Expenses
Pre-tax Income
Less: Income Taxes (40.0%)
Net Income
Plus: Depreciation
Less: Changes in NWC
Less: CAPEX
Cash Flows
Midpoint
Present Value Factor
Present Value of Cash Flows
Sum of Present Value of Cash Flows (With Scenario)
Sum of Present Value of Cash Flows (Without Scenario)
Difference Between Scenarios
TAB
Fair Value
TAB Calculation:
Tax Life (n)
Tax Rate (t)
Discount Rate (r)
Annuity Factor
Mid-Year Adj Factor
TAB Factor
15
40.0%
15.0%
5.85
1.07
20.1%
Working Capital (WC) Calculation
= PV(r, n, -1)
= (1 + r) ^ 0.5
= (n / (n - (Annuity Factor * Mid-Year Adj Factor * t )) - 1)
Accounts Receivable (% of Rev.)
Inventory (% of CoGS)
Accounts Payable (% of CoGS)
5.0%
10.0%
12.0%
Total WC
WC / Revenue
WC Investment
2762
2010
2011
2012
2013
30.0
30.0
36.0
24.0
4.0%
37.5
37.5
45.0
30.0
4.0%
6.0
50.0
50.0
60.0
40.0
4.0%
10.0
60.0
60.0
72.0
48.0
4.0%
8.0
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
© 2016 The Appraisal Foundation
112
2763
Table B.4.b: Hardware Company Without Approach
Revenue Without Existing Customers
Less: Cost of Goods Sold
Gross Profit
Less: Fixed Operating Expenses
Less: Variable Operating Expenses
Less: Incremental "Re-Creation" Expenses
Pre-tax Income
Less: Income Taxes (40.0%)
Net Income
Plus: Depreciation
Less: Changes in WC
Less: CAPEX
Cash Flows
Midpoint
Present Value Factor
Present Value of Cash Flows
Sum of Present Value of Cash Flows (Without Scenario)
Working Capital (WC) Calculation
Accounts Receivable (% of Rev.)
Inventory (Max of % of COGS & Starting Inv.)
Accounts Payable (% of COGS)
5.0%
10.0%
12.0%
Total WC
WC / Revenue
WC Investment
2010
2011
2012
2013
$
600.0
(300.0)
300.0
$
400.0
(200.0)
200.0
$
900.0
(450.0)
450.0
$
1,200.0
(600.0)
600.0
(72.0)
(48.0)
-
180.0
(72.0)
108.0
2010
30.0
30.0
36.0
24.0
4.0%
(90.0)
(32.0)
(10.0)
68.0
(27.2)
40.8
37.5
(2.0)
(37.5)
38.8
$
0.5
0.9325
36.2
$
$
290.5
2011
20.0
30.0
24.0
26.0
6.5%
2.0
(120.0)
(72.0)
(10.0)
248.0
(99.2)
148.8
50.0
(10.0)
(50.0)
138.8
$
1.5
0.8109
112.5
$
(144.0)
(96.0)
(5.0)
355.0
(142.0)
213.0
60.0
(12.0)
(60.0)
201.0
$
2.5
0.7051
141.7
$
2012
45.0
45.0
54.0
36.0
4.0%
10.0
2013
60.0
60.0
72.0
48.0
4.0%
12.0
Comments:
> Cost of Goods Sold are a stable % of revenue. As such, their levels reflect revenue levels.
> Operating Expenses are assumed to be 20% of revenue in the With scenario, with 60% fixed (i.e., unchanged in the Without scenario)
and 40% variable (i.e., a function of revenue levels in the Without scenario).
> The Incremental "Re-Creation" Expenses are those required to re-create the lost customer relationships.
> The Pre-Tax Income reflects the offsetting effects of lower COGS and Operating Expenses in conjunction with higher
Re-Creation expenses.
> Working capital was projected by modeling A/R, Inventory and A/P.
A/R is modeled as a constant percent of revenue, as such it declines when revenue declines.
Inventory is modeled as the greater of a % of COGS or starting Inventory. This reflects the expectation management would not
liquidate inventory they could sell after a modest period of time.
A/P is modeled as a constant percent of COGS, as such it declines when COGS declines.
The overall working capital source/use reflects the contrasting impacts of these items.
> Depreciation and capex are the same as the With scenario as it is assumed there are no changes to the fixed asset base.
2764
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
© 2016 The Appraisal Foundation
113
2765
Testing Outputs
2766
2767
The value of the customer relationships was estimated to be $137.3 million, or approximately 6.5% of the
total purchase consideration. This is reasonable given the following factors:
2768
2769
2770
2771
2772
2773
2774
2775
2776
2777
2778
2779
2780
2781
a. The customers are attracted and retained due to the technology (i.e., valuation specialist
determined that the technology is a primary asset and the customers are not a primary asset).
b. The technology asset value conclusions were significantly higher than the customer relationship
value conclusion and were determined by management to be a primary rationale of the transaction.
c. Manufacturers purchase these components due to their quality and ability to meet rigorous
specifications, suggesting more value emphasis on the product/technology versus customer
relationships.
In a hypothetical scenario where the company no longer has its customers, it would quickly regain them
due to the need for its hardware components. Use of the With-and-Without Method is consistent with the
nature of these relationships. It appears reasonable in that it returns a value that is a relatively small
portion of the purchase consideration. A customer-relationship asset that has a longer life may be
considered a more significant asset to the business economics. A more substantial portion of the purchase
consideration was ascribed to the technology, both developed and in-process, which is consistent with the
business drivers and the purchase rationale.
APB VFR Valuation Advisory #2 - The Valuation of Customer-Related Assets
© 2016 The Appraisal Foundation
114
Intangible assets in
a business combination
Identifying and valuing intangibles under IFRS 3
November 2013
Important Disclaimer:
This document has been developed as an information resource. It is intended as a
guide only and the application of its contents to specific situations will depend on the
particular circumstances involved. While every care has been taken in its presentation,
personnel who use this document to assist in evaluating compliance with International
Financial Reporting Standards should have sufficient training and experience to do so.
No person should act specifically on the basis of the material contained herein without
considering and taking professional advice. “Grant Thornton” refers to the brand
under which the Grant Thornton member firms provide assurance, tax and advisory
services to their clients and/or refers to one or more member firms, as the context
requires. Grant Thornton International Ltd (GTIL) and the member firms are not a
worldwide partnership. GTIL and each member firm is a separate legal entity. Services
are delivered by the member firms. GTIL does not provide services to clients. GTIL
and its member firms are not agents of, and do not obligate, one another and are not
liable for one another’s acts or omissions. Neither GTIL, nor any of its personnel nor
any of its member firms or their partners or employees, accept any responsibility for
any errors this document might contain, whether caused by negligence or otherwise,
or any loss, howsoever caused, incurred by any person as a result of utilising or
otherwise placing any reliance upon it.
Introduction
The last several years have seen an increased focus
by companies on mergers and acquisitions as a
means of stabilising their operations and increasing
stakeholder value by achieving strategic expansion
and cost reduction through business combinations.
Although such transactions can have
significant benefits for an acquiring company, the
related accounting is complex. IFRS 3 ‘Business
Combinations’ (IFRS 3) requires an extensive analysis
to be performed in order to accurately detect,
recognise and measure at fair value the tangible
and intangible assets and liabilities acquired in a
business combination. Furthermore, the interaction
of IFRS 3 with IFRS 10 ‘Consolidated Financial
Statements’ (issued May 2011) and IFRS 13 ‘Fair Value
Measurement’ (issued May 2011) means that this
continues to be both a complex and a developing
area of financial reporting.
The accounting for intangible assets acquired in
a business combination is particularly challenging
for a number of reasons. Intangible assets are by
nature less detectable than tangible ones. Many are
not recognised in the acquiree’s pre-combination
financial statements. Determining their fair value
usually involves estimation techniques as quoted
prices are rarely available.
Where an ‘intangible resource’ is not recognised
as an intangible asset, it is subsumed into goodwill.
Some acquirers might be motivated to report
fewer intangibles, and higher goodwill, because
most intangible assets must be amortised whereas
goodwill is measured under an impairment only
approach. However, a high goodwill figure can
create the impression that the acquirer overpaid for
the acquired business. It also raises questions as to
whether IFRS 3 has been applied correctly. Acquirers
can expect reported amounts of intangible assets
and goodwill to be closely scrutinised by investors,
analysts and regulators.
Accounting for intangible assets in a business
combination is therefore a sensitive area of financial
reporting. Fortunately, Grant Thornton – one of
the world’s leading organisations of independent
assurance, tax and advisory firms with more
than 35,000 Grant Thornton people across over
100 countries – has extensive experience with
business combinations and the related accounting
requirements. Grant Thornton International Ltd
(GTIL), through its IFRS team, develops general
guidance that supports the Grant Thornton member
firms’ (member firms) commitment to high quality,
consistent application of IFRS. We are pleased to
share these insights by publishing ‘Intangible Assets
in a Business Combination’ (the Guide). The Guide
reflects the collective efforts of GTIL’s IFRS team
and the member firms’ IFRS experts and valuation
specialists.
Identifying and valuing intangibles under IFRS 3 2013 i
The Guide includes practical guidance on
the detection of intangible assets in a business
combination and also discusses the most common
methods used in practice to estimate their fair value.
It provides examples of intangible assets commonly
found in business combinations and explains how
they might be valued.
An overview of IFRS 3 summarising the main
aspects of accounting for business combinations
as a whole that draws out a number of practical
points to consider may also be found in GTIL’s
guide: ‘Navigating the accounting for business
combinations: applying IFRS 3 in practice’
(December 2011).
The Guide includes practical
guidance on the detection of intangible
assets in a business combination and
also discusses the most common
methods used in practice to estimate
their fair value.
This Guide is organised as follows:
•
Section A explains the general procedures
necessary to detect intangible assets in a
business combination. It outlines some of the
strategies that are commonly used to detect
acquired technologies, trademarks,
and other resources that may meet the
definition of identifiable intangible assets
in a business combination
Section B explains fundamentals of fair
value measurement as well as common
methods to estimate the fair value of
intangible assets. Key inputs for each
method are identified and various examples
further illustrate the issue
Section C explains the characteristics of
intangible assets that are frequently found
in practice and common methods used to
estimate their fair value. Factors that will
usually impact their fair value measurement
are also discussed.
•
•
• Case Study.
Grant Thornton International Ltd
November 2013
ii Identifying and valuing intangibles under IFRS 3 2013
Contents
Introduction
A. Detecting intangible assets
1 General requirements
1.1 Definition of an intangible asset
1.2 Identifiability
2. Strategies to detect identifiable intangible assets
2.1 Business model review
2.2 Other important sources
2.3 Determining which identifiable intangible assets require measurement
3. Common identifiable intangible assets
B. Measuring intangible assets
1. General approaches to fair value
1.1 Which approach to use?
1.2 ‘Cornerstones’ of fair value measurement in business combinations
2. Market approach methods
2.1 Key inputs
2.2 Sales transactions comparison method
2.3 Methods using market multiples
3. Cost approach methods
3.1 Key inputs
3.2 Reproduction cost method
3.3 Replacement cost method
4. Income approach methods
4.1 Key inputs
4.2 Relief-from-royalty method
4.3 Comparative income differential method (CIDM)
4.4 Multi-period earnings excess method (MEEM)
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C. Common intangible assets in business combinations
1. Marketing-related intangible assets
1.1 Trademarks, service marks and related items
1.2 Internet domain names and websites
1.3 Non-compete agreements
2. Customer-related intangible assets
2.1 Customer lists or similar databases
2.2 Customer contracts: open orders and production backlogs
2.3 Customer relationships
3. Technology-related intangible assets
3.1 Third-party software licenses
3.2 Technology (other than third-party software)
4. Other contract-related intangible assets
4.1 Reacquired rights
4.2 Operating lease contracts; licensing arrangements; other user rights, including
supplier agreements
5. Assembled workforce
Case Study – Service Provider
1. Trade name
2. Service provider number
3. Customer relationships
4. Non-compete agreements
5. Summary of intangible assets’ fair values
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A. Detecting intangible assets
Recognition and fair value measurement of all of the acquiree’s identifiable assets and liabilities at the
acquisition date are amongst the key elements of the acquisition method required by IFRS 3. The method
implies that all assets and liabilities are known to the acquirer. In practice however, detecting or ‘finding’
identifiable intangible assets in particular may be a complex matter which requires intensive research into the
acquired business.
How does the acquirer determine which intangible assets need to be recognised separately from
goodwill? This Section provides insights into how to go about doing this. The general requirements for
identifiability and the definition of an intangible asset are explained. The Section also discusses how
identifiable intangible assets are detected in practice, complemented by a list of intangible assets that should
be considered in business combinations.
1. General requirements
Economically, many intangible ‘resources’, ‘value drivers’ or ‘advantages’ are essential parts of a business.
However, in accounting for business combinations these have to be analysed from two different perspectives
in order to determine what should be recognised separately from goodwill: the resource must meet the
definition of an intangible asset and it must be ‘identifiable’ as part of what is exchanged in the business
combination (rather than in a separate transaction or arrangement).
1.1 Definition of an intangible asset
The acquirer must first assess which resources meet the definition of an asset in accordance with ‘The
Conceptual Framework for Financial Reporting’ (the Conceptual Framework) at the acquisition date. The
Conceptual Framework defines an asset as follows:
Definition of an asset (Conceptual Framework paragraph 4.4(a))
An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are
expected to flow to the entity.
In addition, an intangible asset other than goodwill is defined as “an identifiable non-monetary asset without
physical substance” (IFRS 3.Appendix A). The first step to detect intangible assets in a business combination
is to find future economic benefits that are controlled by the entity at the date of acquisition as a result of the
business combination. Potential intangible assets could take the form of additional income (or cost savings)
and should therefore be capable of directly or indirectly increasing future cash flows.
Detecting the relevant identifiable assets is not affected by specific exemptions in IFRS 3 or other
standards. For example, it does not matter whether or not an intangible asset was recognised in the
acquiree’s financial statements prior to the combination (IFRS 3.13). In fact, the acquired entity may have
been subject to specific restrictions in International Accounting Standard 38 ‘Intangible Assets’ (IAS 38) that
prohibit the recognition of many internally generated intangible assets (IAS 38.51-53). These restrictions do
not apply to business combination accounting – in effect, all resources of the acquired business are regarded
as externally purchased.
Identifying and valuing intangibles under IFRS 3 2013: Section A 1
To recognise an internally generated or separately purchased intangible asset, the potential future
economic benefits expected from its use have to be ‘probable’ (IAS 38.21(a)). However, if an intangible
asset is acquired in a business combination the probability recognition criterion in IAS 38.21(a) is always
considered to be satisfied as uncertainties regarding future economic benefits are reflected in the asset’s fair
value (IAS 38.33).
Finding future economic benefits that may meet the definition of an asset is not impacted by the
buyer’s intentions concerning the future use (or non-use) of an asset. In estimating the fair value of an asset,
the acquirer needs to assume the perspective of a typical market participant. Consideration of the buyer’s
intention or acquirer-specific conditions do not therefore affect the existence or detection of an identifiable
intangible asset (this also applies to its measurement, see Section B.1.2 for further discussion).
1.2 Identifiability
The acquirer must also assess whether the intangible asset in question is ‘identifiable’. Only identifiable assets
are recognised and accounted for independently from goodwill. Identifiability might seem to be
self-evident: an acquirer would not reach this stage in the assessment without first having identified
something to assess. However, ‘identifiable’ has a specific meaning in this context as follows:
Determining when an asset is identifiable (IAS 38.12)
An asset is identifiable if it either:
(a) is separable, ie is capable of being separated or divided from the entity and sold, transferred, licensed, rented, or
exchanged, either individually or together with a related contract, identifiable asset or liability, regardless of whether
the entity intends to do so; or
(b) arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from
the entity or from other rights and obligations.
Intangible assets that arise from contractual or other legal rights are relatively straightforward to detect.
As there is third party-originated evidence of their existence (the contract or the legal right), they meet
the contractual-legal criterion for identifiability. The contractual-legal criterion does not however apply
to contracts or legal rights that are pending or otherwise contingent at the date of acquisition.
If the contractual-legal criterion is not met, the intangible asset must be separable in order to be
identifiable. Broadly, an asset is considered separable if it is capable of being sold or otherwise transferred
without selling the entity in its entirety. Where separation is possible only as part of a larger transaction,
judgment is required to determine whether the items under review constitute the acquired business itself
or a part of it. For example, the content of a database used by a provider of business intelligence may not be
separable from the business itself – there would be no business remaining if the database content was sold
to a third party. By contrast, where the content database is a by-product of the business activity and may be
licensed out to a third party on non-exclusive terms, then this may indicate its separability.
This is a hypothetical assessment. It is not affected by whether the acquirer actually intends to transfer the
intangible asset in question (although such an intention would of course demonstrate separability). Evidence
of exchange transactions for the type of asset under review or a similar type may be used to exemplify the
separability of the asset, “even if those transactions are infrequent and regardless of whether the acquirer
is involved in them” (IFRS 3.B33). A full analysis of the intangible asset and its commercial environment
is therefore necessary to determine whether separation from the acquired business is feasible without
underlying contractual or legal rights.
2 Identifying and valuing intangibles under IFRS 3 2013: Section A
The following table summarises the determination process of whether an asset meets the specific criteria
for recognition as an intangible asset apart from goodwill:
Figure A.1 – Process for determining if an intangible asset meets the criteria to be
separately identified
Identify intangible asset
Non-monetary and lacks
physical substance?
AND
Expected to generate future
economic benefits?
AND
Controlled by the entity at
the date of acquisition?
Yes
Determine whether intangible asset qualifies for separate recognition
Does the intangible asset meet
the contractual-legal criterion?
Does the intangible asset meet
the separability criterion?
OR
Yes
Recognise separate intangible asset at fair value
Example A.1 – Customer relationship (Contractual-legal criterion)
Company H acquires Company I, a supplier of small auto parts. Company I has an agreement in place to supply its
product to Customer A for an established amount of time. Both Companies H and I believe that Customer A will renew
the product supply agreement at the end of the current contract term. The supply agreement cannot be sold or
transferred separately from Company I.
Analysis:
The supply agreement (whether cancellable or not) meets the contractual-legal criterion for identification as a separate
intangible asset. Additionally, because Company I establishes its relationship with Customer A through a contract, the
customer relationship also meets the contractual-legal criterion for identification as an intangible asset. Therefore the
customer relationship intangible asset is also recognised separately apart from goodwill provided its fair value can be
measured reliability.
Example A.2 – Database used in a supporting activity (Separability criterion)
Company Q acquired Company R, a retailer. Company R owns a database, used in managing its loyalty scheme, which
captures information on customer demographics, preferences, relationship history and past buying patterns. The
database can either be sold or licensed. However, Company R has no intentions to do so because it will negatively
impact its operations.
Analysis:
In this situation, the database does not arise from a contractual or legal right. Thus, an assessment of its separability is
required. The database and content were generated from one of Company R’s supporting activities (ie management of the
loyalty scheme) and could be transferred independently of the rest of the business. The actual intention not to transfer the
database does not affect the assessment. The separability criterion is met and the database is recognised as an intangible
asset in the business combination.
Identifying and valuing intangibles under IFRS 3 2013: Section A 3
Example A.3 – Licensed use of patent (Contractual-legal criterion)
Company D owns a technology patent. It has licensed that patent to others for their exclusive use outside the domestic
market, receiving a specified percentage of future foreign revenue in exchange.
Analysis:
The acquirer of Company D would recognise an intangible asset for both the technology patent and the related license
agreement. The technology patent is protected legally and therefore meets the contractual-legal criterion. Additionally, the
license agreement would meet the contractual-right criterion for recognition separately from goodwill even if selling or
exchanging the two intangible assets separately from one another would not be practical.
2. Strategies to detect identifiable intangible assets
Detecting intangible assets can be a complex and challenging matter. Strategies to detect identifiable
intangible assets vary depending on the facts and circumstances of the business combination and usually
require a full review of the transaction. It is important to understand the business of the acquiree, what
intangible resources it depends on and how these may translate into identifiable intangible assets. It should
be possible to explain the acquired business in terms of the resources it uses to generate profits and how
these are reflected in the acquiree’s assets and liabilities. In other words ask the question: what has been
paid for?
Practical insight – linking identified intangibles to the business and transaction
• does the purchase price allocation take into account all relevant data (examples include the purchase agreement,
due diligence reports and current information, both public and internal)?
• has the business model been reviewed?
• has the purchase agreement been reviewed for intangible assets that are specifically mentioned, such as
non-compete agreements or other intangible resources that are of importance?
• were the acquired entity’s official documents and contractual arrangements reviewed for patents, trademarks and
similar rights of use, access or protection that may represent economic resources?
•
is it possible to explain the business model of the acquiree in terms of the detected assets?
2.1 Business model review
A thorough review of the acquiree’s business is the most important step in detecting intangible assets in a
business combination. Understanding the business rationale for the combination, the acquiree’s business
resources and how the acquired business generates revenues provides the most useful insights into its
intangible assets.
Review of financial information
A review of historical and prospective financial information is often a good starting point to understand
the relative importance of non-current tangible assets as well as working capital (ie cash and cash
equivalents, inventories and work in progress, trade receivables and payables). These assets are usually
readily observable as they are included on the acquiree’s balance sheet.
Intangible assets are often not included either in internal financial information used in the acquired
business or in its published financial statements (if any). However, financial information is likely to provide
important indirect indicators. For example, high marketing-related expenditure may be an indicator of
the relative importance of trademarks and similar marketing-related intangible assets. If the entity incurs
significant expenditure on research and development, it is likely to generate technology-based intangible
assets. The relative significance of expenses that are related to customer care may point to the significant
customer relationship intangible assets.
4 Identifying and valuing intangibles under IFRS 3 2013: Section A
Characteristics of the acquired business
The review of financial information should be accompanied by a full commercial analysis of the
acquired business:
•
the product portfolio may provide further useful insights into the existence and characteristics of
technology-based intangible assets. If current or new products are based on what is sometimes referred
to as ‘core technology’ or a common ‘product platform’, then further analysis should assess the role of the
underlying technology
the relative importance of branding or other marketing strategies needs to be assessed to determine the
existence of marketing-related intangible assets such as trademarks, brands, logos or similar assets
• an analysis of the customer base is usually carried out to determine whether identifiable customer
•
relationship intangible assets exist. Whether the customers are known to the business, their behaviour
and loyalty may all be considered in detecting a related intangible asset
•
• where a business depends on specific rights of use, such as access to license agreements or rare supplies
of raw material, then this may indicate supplier-related contractual intangible assets. Examples are
long-term energy or metal supply agreements. Permits to operate or service-specific assets such as a
hydroelectric power plant, a TV station or simply a property under a lease contract are also examples of
specific rights of use (amongst many other examples)
if business locations are crucial, for example if the acquired business is a retailer, then this may also
indicate value. However, in cases other than operating lease contracts, this is generally not an identifiable
intangible asset, but a measurement element of the underlying property
the acquiree’s workforce is also often considered a key asset of the business under review. The existence
of a well-trained and organised team saves the acquirer from having to hire and train the people
necessary to run the business and thus represents future economic benefits. Nevertheless, recognition
of the assembled workforce is specifically prohibited under IFRS 3.B37 and IAS 38.15. The workforce may
however affect the fair value measurement of other intangible assets (see Section B.4.4)
industry-specific intangible assets may be identified by assessing the relevance of assets typically found
in a specific economic environment. For example, customer ‘core deposits’ may be a typical example for
an intangible asset commonly found in financial institutions. Other industries may rely on copyrighted
material, such as pictures or photographs or similar ‘artistic intangibles’.
•
•
Management’s judgment
The business model review should be complemented by management’s judgment. The acquirer’s
management usually has post-combination objectives and may already have identified the acquiree’s
resources – both tangible and intangible – in developing its post-combination strategy. This may not directly
‘translate’ into the general requirements for identifiable intangible assets under IFRS 3, but nevertheless
draws out key elements of the acquired business that represent value for the acquirer. It may also be helpful
to take into account the judgment of the acquiree’s management team as it has experience with the business
model and existing key inputs that may be ‘translatable’ into identifiable intangible assets.
2.2 Other important sources
The purchase agreement that affects the business combination is usually a very important source in finding
potential identifiable intangible assets. The agreement and its accompanying annexes and disclosure
documents will usually refer to specific trademarks, patents and other intangible assets that are established
by contractual or other legal rights. Legal, accounting and commercial due diligence reports (if available)
are also likely to contain important references. For example, often times there are information
memorandums prepared on the target business. Additionally, any Board approval documents may
be useful as reference materials.
Identifying and valuing intangibles under IFRS 3 2013: Section A 5
The detection of identifiable intangible assets depends on the context of the acquisition. Useful sources
to detect identifiable intangible assets in the context of a business combination are for example:
Source of information
Possible indicators
Acquiree’s financial statements and other internal reports
•
some intangible assets will have been recognised in the acquiree’s
financial statements. Other financial statement information may also
provide indirect indicators, for example:
–
significant marketing costs may be an indicator of the relative
importance of brands, trademarks and related intangible assets
significant expenditures on research and development may indicate
the existence of technology-based intangible assets
significant expenditures related to customer care may point to
customer relationship intangible assets
–
–
Purchase agreement and accompanying documents
Due diligence reports
Website materials, press releases and investor relation
communications
Industry practice
•
•
•
•
•
•
may include references to certain trademarks, patents or other intangible
assets that are established by contract or legal rights
may include non-compete provisions that sometimes give rise to a
potential intangible asset
may include information that assists in understanding the acquired
business, resources and how revenues are generated
the website may contain discussions of the unique characteristics of the
business which may translate into a potential intangible asset
press releases and investor relation communications of both the acquiree
and the acquirer may include discussions of potential intangible assets
results of similar business combinations may provide indicators of the
types of intangible assets that are typically recognised in such situations
Both parties to a business combination may have also expressed their views on potential intangible
assets in external documents that relate to the combination. It may therefore also be necessary to review
website material and press releases of both the acquirer and the acquiree. These tend to point out unique
characteristics of the business under review, which in turn may translate into identifiable intangible assets.
Where records are not readily available from the acquired business, it may also be helpful to contact the
relevant authorities to ensure the completeness of potential intangible assets that are legally protected
through a registration (such as trademarks or patents).
The acquiree may have reported various intangible assets in its pre-combination financial statements.
This is clearly a useful indicator of identifiable intangible assets but further analysis will be required. Typically,
intangible assets recorded by the acquiree will be purchased assets that meet the contractual-legal criterion.
However, some items recorded by the acquiree may not qualify for recognition in accordance with IFRS.
Some GAAPs require or allow, for example, the recognition of start-up costs – these do not meet the
definition of an asset under IFRS. Goodwill previously recognised by the acquiree should also not be taken
into consideration. Conversely, some assets that have been fully depreciated or amortised by the acquiree
may still be in use and meet the definition of identifiable intangible assets.
2.3 Determining which identifiable intangible assets require measurement
A complete review of the acquired business’s intangible assets is necessary to enable proper implementation
of IFRS 3. However, not every identifiable intangible asset needs to be measured and recognised individually:
• some assets are grouped with other assets on the basis of the specific requirements in IFRS 3 and
IAS 38
• similar identifiable assets may also be combined for practical reasons or to avoid double-counting
• some identifiable intangible assets may be considered immaterial.
6 Identifying and valuing intangibles under IFRS 3 2013: Section A
Comparing international rules – proposed amendments to US GAAP
At the time of publication of this Guide, the U.S. Financial Accounting Standards Board (FASB) has issued a proposed
Accounting Standards Update (ASU) reflecting alternative accounting guidance proposed by the Private Company
Counsel (PCC). The proposed ASU, ‘Accounting for Identifiable Intangible Assets in a Business Combination’, offers
private companies that report under U.S. GAAP an alternative in recognising, measuring and disclosing certain
identifiable intangible assets that are acquired in business combinations.
The proposal in its current form would allow private companies an alternative election to recognise certain acquired
intangible assets together with goodwill, unless the identifiable intangible asset arises from a non-cancellable contract or
other legal rights, whether or not those intangible assets are transferable or separable. Those assets arising from non-
cancellable contracts would be measured at fair value in accordance with FASB Accounting Standards Codification®
(ASC) 820, ‘Fair Value Measurement’, except that the measurement would consider only market participant assumptions
about the remaining non-cancellable term (and therefore would exclude potential renewals or cancellations that otherwise
would be considered in the measurement). The measurement of an identifiable intangible asset arising from other legal
rights but that are not contractual in nature would continue to be measured at fair value under ASC 820; however, unlike
the contractual rights, all market participant expectations would continue to be considered. An entity would be required
to disclose qualitatively the nature of identifiable intangible assets acquired but not recognised separately from goodwill.
The proposed amendment is meant to address concerns about the cost and complexity of estimating the fair value
of certain identifiable intangible assets and would be less subjective than the existing U.S. GAAP requirements because it
would reduce the number of required assumptions being made by the acquiring entity.
Impact:
If the proposed amendments are adopted, many private companies reporting under U.S. GAAP would recognise fewer
intangible assets in a business combination than what is required under IFRS 3 and as currently required under
U.S. GAAP (ASC 805).
Groups of intangible assets
Generally, all identifiable intangible assets that are acquired in a business combination are measured
independently. Nevertheless, intangible assets that do not meet the contractual-legal criterion for
identifiability but are otherwise separable from the acquired entity may sometimes only be separable as a
group with (an)other tangible or intangible asset(s). This situation may cause problems in measuring the
individual fair value of the intangible asset reliably. In these circumstances, the group of assets may be treated
as a single asset for accounting purposes, including fair value measurement (IAS 38.36).
Example A.4 – Interdependencies of core technology and customer relationship assets
In a business combination, both a customer relationship intangible asset and core technology are detected as identifiable
intangible assets. The core technology is used to generate income from ongoing customer relationships. The customer
relationships, on the other hand, cannot be used to generate any income that does not relate to the core technology.
Analysis:
In this scenario a detailed assessment is required to determine whether these resources need to be combined for
accounting (and measurement) purposes or whether they are two separable assets.
A similar principle applies to certain groups of complementary assets that comprise a brand. In accordance
with IAS 38.37 the acquirer combines a trademark or a service mark and other related intangible assets
into a single identifiable intangible asset if the individual fair values of the complementary assets are
not measureable reliably on an individual basis. IFRS also permits a combined approach for groups of
complementary intangible assets comprising a brand even if fair values of individual intangible assets in the
group of complementary assets are reliably measurable provided the useful lives are similar (IAS 38.37).
Identifying and valuing intangibles under IFRS 3 2013: Section A 7
Example A.5 – Complementary assets comprising a brand
The cutting edge ‘XY’ core technology is considered an identifiable intangible asset in a business combination. All of the
acquiree’s products are based on ‘XY’ and the technology is also advertised to customers under the ‘XY’ brand using a
website that is accessible under www.xy.com. The ‘XY’ brand is protected against third-party use by a registered
trademark and no other technology can be reasonably marketed using this trademark. The www.xy.com domain name is
also registered. It is expected that when XY technology is withdrawn from the market, then the trademark and the
domain name will both be of little or no value. The remaining useful life of the three different intangible assets is
expected to be similar.
Analysis:
Given the fact pattern, the acquirer concludes that neither the trademark nor the domain name would be reliably
measurable without taking into account the core technology they relate to. The core technology, the trademark and the
domain name are therefore considered a single identifiable intangible asset.
Other combinations of assets with similar economic characteristics
Although IFRS refers to combining intangible assets only in limited circumstances (as described above),
judgment is required in practice to determine the appropriate level of aggregation. This is sometimes referred
to as the ‘unit of account’ issue. In the absence of specific guidance on unit of account issues, it may be
appropriate to extend the approach set out for brands to groups of similar assets in general.
Materiality considerations will often justify treating large groups of similar assets (eg customer
relationship assets) on a portfolio basis. However, in determining whether separate identifiable intangible
assets may be similar enough to be measured on a combined basis consideration should be given to:
• general characteristics of the intangible assets under review
• related services and products
•
• similar legal or regulatory conditions that affect the intangible assets
• geographical regions or markets
the economic lives of the assets.
•
functionality and/or design and other shared features of the intangible assets
These factors may result in reporting different intangible assets on a combined basis (or even combinations
of intangible and tangible assets). Material, identifiable intangible assets should not however be combined
with goodwill. If similar intangible assets are combined for measurement purposes they should in our view
also be accounted for subsequently on the same combined basis.
The acquirer entity should not measure the intangible assets on a combined basis and then disaggregate
them for subsequent amortisation purposes.
Example A.6 – Different patents relating to same technology
A number of different patents which all relate to the same technology are identified in a business combination. It is
concluded that the patents contribute to the same income stream. The patents also have similar remaining useful lives
and are therefore considered as a portfolio. As a result, the entity then measures, recognises and subsequently
accounts for the underlying core technology rather than a number of different intangible assets.
Example A.7 – Customer bases in separate markets
SalesCorp is active in the North American market as well as in the European market. SalesCorp’s customers in North
America are independent from its customers in Europe. SalesCorp also provides different products to its different groups
of customers. Given these circumstances, and providing that the asset definition and the identifiability criteria are met,
it is decided that SalesCorp has two customer bases that should be accounted for as separate identifiable
intangible assets.
Depending on the facts
and circumstances, it
may be preferable to
combine similar assets
for measurement
purposes and
subsequent accounting.
8 Identifying and valuing intangibles under IFRS 3 2013: Section A
Materiality considerations
It is not necessary to measure the fair value of specific intangible assets if they are demonstrably immaterial.
Both qualitative and quantitative factors should be considered in evaluating materiality. Indicators of
materiality (or immateriality) might include:
•
the function of the identifiable intangible asset in the business model – can the business model be
explained without the intangible asset?
• will the acquired entity ‘maintain’ the subject asset – ie will it incur significant expenditure necessary to
•
protect its value, and will it monitor relevant rights?
the remaining useful life of the intangible asset. Extended remaining useful lives may result in future
economic benefits that are not available in the short term and which are therefore not immediately
perceptible. Future economic benefits of the intangible asset under review may nevertheless be material.
Example A.8 – Consideration of materiality
An entity acquires a patent in a business combination. The patent meets the definition of an asset and also the
contractual legal-criterion for identifiability. However, the patent protects outdated technology that is almost irrelevant for
products and services in the relevant markets at the date of acquisition. Furthermore, the patent protection will expire in
less than two years from the date of acquisition. It is therefore concluded that the patent’s fair value is immaterial.
3. Common identifiable intangible assets
These steps describe general approaches for detecting identifiable intangible assets in a business
combination. Practitioners also often ask for a ‘checklist’ of the intangible asset types most commonly
identified in business combinations. Any such checklist should be treated with a degree of caution. Best
practice is to maintain a wide focus in the detection phase so that relevant identifiable intangible assets are
not overlooked. The intangibles to be identified vary in each case and depend greatly on the industry of the
acquired business and the circumstances of the business combination.
Despite the limitations of any checklist, a list of common examples can help to focus the analysis and
provide an indication of possible end results. Accordingly, Section C of this Guide discusses a number
of intangible asset types that are commonly detected in business combinations, including customer
relationships, trademarks or non-compete agreements (and common measurement methods used to
estimate their fair values).
Illustrative examples within IFRS 3
The illustrative examples accompanying IFRS 3 also provide a number of potential identifiable intangible
assets that commonly meet the definition of intangible assets in business combinations, along with some
further explanations. These examples are summarised below:
Identifying and valuing intangibles under IFRS 3 2013: Section A 9
Figure A.2 – Examples of identifiable assets acquired in a business combination
(Extract from IFRS 3.IE16-44)
Marketing related
Customer related
Artistic related
Contract based
Technology based
Trademarks, trade names, service marks, collective marks and certification marks
Trade dress (unique colour, shape or package design)
•
•
• Newspaper mastheads
•
Internet domain names
• Non-competition agreements
• Customer lists*
• Order or production backlog
• Customer contracts and the related customer relationships
• Non-contractual customer relationships*
• Plays, operas and ballets
• Books, magazines, newspapers and other literary works
• Musical works such as compositions, song lyrics and advertising jingles
• Pictures and photographs
•
Video and audiovisual material, including motion pictures or films, music videos and
television programmes
Licensing, royalty and standstill agreements
•
• Advertising, construction, management, service or supply contracts
•
License agreements
• Construction permits
•
• Operating and broadcasting rights
• Servicing contracts such as mortgage servicing contracts
• Below-market employment contracts that are beneficial from the employer’s perspective
• Use rights such as drilling, water, air, mineral, timber-cutting and route authorities
Franchise agreements
• Patented technology
• Computer software and mask works
• Unpatented technology*
• Databases, including title plants*
•
Trade secrets such as secret formulas, processes or recipes
*Item is usually identifiable by satisfying the separability criterion
Economic benefits that usually do not constitute identifiable intangible assets
Other resources are commonly found in business combinations but do not meet the definition of an
identifiable intangible asset. As such, they may affect the value of other assets, liabilities and contingent
liabilities or they are simply included in goodwill. Normally, they would however not be recognised as
identifiable intangible assets:
Previously recognised goodwill
Previously recognised goodwill does not arise from contractual or other legal rights. It is
also not capable of otherwise being separated or divided from the entity in a hypothetical
transaction.
Assembled workforce
The assembled workforce is not considered identifiable (IFRS 3.B37). IAS 38 also points out
that there is usually insufficient control over the economic benefits that may result from the
assembled workforce (IAS 38.15).
Synergies
Synergies are usually not identifiable as they do not depend on contractual or other legal rights
and they are usually not capable of being separated from the acquired entity.
Market share, market potential,
monopoly situations or similar
‘strategic values’
A robust position in the market may enhance the actual value of identifiable marketing-related
or technology-driven intangible assets. However, the acquiree’s market share or market
condition is itself not an identifiable intangible asset as this economic condition does not
describe a controllable potential future economic benefit.
High credit or going concern
Value is sometimes attributed to a high credit rating or other indicators of the sustained ability
of the acquiree to operate as a going concern and these factors may affect the cost of the
combination. However, these values do not normally meet the criteria for identifiability and are
not controllable future economic benefits.
While these items are usually not recognised separately from goodwill under IFRS, they may still be
important or even essential to the acquired business. As discussed in Section B, some of these items (the
assembled workforce for example – Section B.3.2 and B.4.4) may need to be valued in order to determine the
values of other assets that do need to be recognised.
10 Identifying and valuing intangibles under IFRS 3 2013: Section A
B. Measuring intangible assets
IFRS 3 requires that most identifiable assets and liabilities acquired in a business combination are recorded
by the acquirer at fair value. However, IFRS 3 (and other Standards) provides only limited guidance on how
fair value should be determined. Different estimation techniques have therefore emerged in practice. Their
underlying concepts, the actual methodologies and the key inputs required to apply them are discussed in
the following Section.
1. General approaches to fair value
With the release of IFRS 13 in May 2011, the definition of fair value was clarified as:
Definition of fair value (IFRS 13 Appendix A)
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date.
The fair value concept is therefore based on what is sometimes described as a hypothetical ‘exit’ transaction
– the exchange or settlement of the asset or liability in question at a specified date. Fair value is the amount
that would be paid or received in this hypothetical transaction. It also follows that fair value is an estimate –
not an absolute or definitive amount.
Specific valuation models and techniques have emerged for estimating fair values, or for providing
inputs into such estimates. These models and techniques can be grouped into three broad approaches. The
selection of the appropriate approach, technique or combination of techniques depends both on the nature
of the asset in question and the availability and reliability of the information available to apply the technique.
The three broad approaches are summarised below:
Figure B.1 – Three broad approaches for estimating fair values
Market approach
Income approach
Cost approach
Sales Transactions Comparison
Method
Relief-from-Royalty Method
Market Multiples Method
Comparative Income Differential
Method (CIDM)
Reproduction Cost
Method
Replacement Cost
Method
Multi-Period Excess Earnings
Method (MEEM)
Direct Cash Flow Method
Limited
Frequency of use
Extensively
Rarely
Identifying and valuing intangibles under IFRS 3 2013: Section B 11
Market approach
The market approach provides an indication of the fair value by comparing the asset under review to similar
assets that were bought and sold in recent market transactions. A fair value estimate is generally derived from
the transaction price for an asset or a number of similar assets for which observable market data is available.
Intangible assets are typically transferred only as part of selling a business or in a licensing agreement.
Observable market data is therefore often limited. The information that is available may relate to similar
(but different) assets and therefore require complex modifications to reflect the characteristics of the
subject asset. Even if a quoted price is available, it is not always the most appropriate measure of fair value
– the quoted price could be affected by a lack of liquidity in the market or other distortional factors and
therefore not be representative of the price at which a typical market participant would actually transact.
The market approach is therefore less frequently used in practice to estimate the fair value of an intangible
asset in a business combination.
Income approach
Valuation methods following the income approach estimate the price an asset could be sold for in an arm’s
length transaction on the basis of the asset’s expected future income stream. This involves estimating the
present value of future economic benefits attributable to the owner of an asset and incorporating as much
observable market data into the valuation as possible. All methods that follow this approach therefore rely
heavily on projected financial information (PFI) and use discount rates.
In practice, income approach-based methods are the most commonly applied for the fair value
measurement of intangible assets acquired in a business combination. These methods may appear
hypothetical in that they aim to reconstruct the measurement process a typical market participant would
implement. The key advantage of the income approach; however, is that it involves fair value measurement
by direct reference to the asset’s expected future economic benefits.
Cost approach
The cost approach seeks to estimate fair value by quantifying the amount of money that would be required
to repurchase or reproduce the asset under review. The cost approach also takes into account physical
deterioration (usually not a factor with intangible assets) and use as well as technological and economic
obsolescence if relevant.
Conceptually, cost-based approaches are a less robust basis for a fair value estimate than a market or
income approach (see below). Moreover, the cost of replacing or reproducing an intangible asset may
be particularly difficult to measure if the asset is unique. Cost-based measures may also ignore future
economic benefits of owning the asset that would influence the price that a willing buyer would pay. For
all these reasons the cost approach is less widely accepted than market and income approaches.
1.1 Which approach to use?
There is no ‘right’ or universally accepted approach to determine the fair value of intangible assets. Fair
value measurement always requires professional judgment to develop assumptions and estimates and
depends on the actual facts and circumstances of the transaction. Different estimates of fair value may
be both justifiable and reasonable. Consequently, two different parties valuing the same intangible asset
are not likely to arrive at the same result. As much as fair value measurement should anticipate the value
a third party would attribute to the subject asset, there is always a ‘grey area’ of uncertainty (or, put
another way, a range of prices at which hypothetical market transactions might take place). Nevertheless,
there are certain minimum conceptual characteristics every fair value estimate should reflect. These are
discussed in the following paragraphs.
12 Identifying and valuing intangibles under IFRS 3 2013: Section B
1.2 ‘Cornerstones’ of fair value measurement in business combinations
A few conceptual qualities of fair value hold true for every measurement of intangible assets in a business
combination. In addition, IFRS 3 sets out a few special requirements for special intangible assets acquired in
a business combination. All of these aspects have to be taken into account when estimating the fair value of
intangible assets in business combinations.
Considering some of the conceptual characteristics of fair value and specific requirements of IFRS 3:
• are all assets, liabilities and contingent liabilities measured consistently as at the date of acquisition?
• does the measurement of fair value utilise as much observable market data as possible?
• does the valuation assume the position of a typical market participant and omit synergies and intentions that are
specific to the actual acquirer?
• does the valuation avoid ‘blends’ between different approaches to fair value?
• does acquisition date fair value measurement incorporate all specific measurement requirements of IFRS 3?
Date of valuation
A fair value measure is an attempt to estimate the price market participants would pay on a specific date.
In a business combination this is the acquisition date (IFRS 3.18). The acquisition date is the date on which
the acquirer obtains control over the acquiree (IFRS 3 Appendix A).
Concept of control: new definition (IFRS 10.6)
With the release of IFRS 10 in May 2011, the IASB redefined ‘control’ and established extensive guidance on applying the
new definition. Under the new definition, an investor has control over an investee when it “is exposed, or has rights, to
variable returns from its involvement with the investee and has the ability to affect those returns through its power over
the investee” (IFRS 10.6). While the changes in the definition will have little or no practical effect on determination of
control in most simple situations involving control through ownership of a majority of the voting power in an investee,
situations that are more complex may require additional assessment and could affect the scope of consolidation. For a
more in-depth discussion of the application of the control concept under IFRS 10, please refer to the separate GTIL
publication ‘Under Control? A Practical Guide to Applying IFRS 10 Consolidated Financial Statements’ (August 2012). The
updated definition under IFRS 10 contains different concepts of control than under U.S. GAAP and certain other
reporting frameworks, which may lead to instances where control is established under one framework’s definition but
not under another.
In practice, the fair value estimates are of course made some time after the acquisition date. However, the
estimate should take account only of information that existed at the date of acquisition. In this sense, the use
of hindsight is not permissible – market participants are able to price an asset only on the basis of information
that exists at the time they set the price.
The requirement to use acquisition date fair values should be distinguished from the measurement
period that is permitted under IFRS 3.45 (up to one year from acquisition date) to finalise the accounting
procedures. The period allows the acquirer to collect information about conditions at the acquisition date
and also to complete the valuation process making use of that information.
Example B.1 – Finalisation of fair value during measurement period
An entity detects intangible assets A and B in a business combination that relate to important new product development
projects of the acquiree. The business combination was effected shortly before year end and due to the limited time
available to finalise the fair value measurement of the intangible assets, provisional amounts are reported in the
consolidated financial statements. Provisional fair values of CU1,000 for both assets were estimated based on various
assumptions about the readiness of the new product designs. In particular it was assumed that product testing was
completed before the acquisition date and that both products would be ready to market within 12 months.
After the financial statements have been authorised and published, the entity continues to investigate the status of
the two product developments at the acquisition date in order to finalise the business combination accounting within the
12-month window permitted by IFRS 3.
Identifying and valuing intangibles under IFRS 3 2013: Section B 13
Intangible asset A
On further investigation, it is found that the product testing for product A was not complete at the date of acquisition.
Hence, time to market would have been more reasonably estimated at 24 months as at the date of acquisition. This
would have resulted in an acquisition date fair value of CU750. As this information relates to conditions at the date of
acquisition and was obtainable at that date, the acquisition date fair values are adjusted to incorporate the revised fair
value estimate of CU750.
Intangible asset B
With product B, the acquirer’s investigations confirm that product testing had been completed at the acquisition date,
with positive results. However, after the date of acquisition new technical problems emerge with the commercial
production of product B. This delays the expected time to market by a further 12 months. In this case, the new
information obtained relates to events occurring after the date of acquisition and did not exist at that date. All else being
equal, the initial fair value estimate for product B is not changed in accounting for the business combination (although it
may be necessary to record an impairment loss in the post-combination financial statements).
Valuation from the perspective of the typical market participant (ignoring buyer’s intention)
Fair value should be determined from the perspective of a hypothetical buyer who is referred to as ‘the
typical market participant’. Assuming the perspective of the typical market participant requires a stand-alone,
independent valuation of each intangible asset (or appropriately grouped combination of assets when the
previously-discussed criteria for grouping are met: see Section A.2.3).
The market participant assumed in fair value measurement should:
• be a third party that is independent of the combined business – for example a competitor in the same
industry or sometimes even a financial investor
• have reasonable understanding about the subject asset, based on all available information that is readily
available or available through due diligence efforts that are usual and customary
• be able and willing to transact for the subject asset without being compelled to do so.
The focus on market participants in general also means that specific intentions of the acquirer (sometimes
referred to as ‘buyer’s intention’) do not affect fair value measurement (IFRS 3.B43). The intention to stop
using an asset does not mean that the fair value of this asset is insignificant – other willing buyers may be
prepared to pay for the asset in question.
Example B.2 – Buyer’s intention not to be reflected in fair value
A frequent scenario occurs in connection with trademarks or similar marketing-related intangible assets. These are
sometimes discontinued as a result of the post-acquisition strategy of the combined entities. The acquirer must value
these from the third-party perspective of a typical market participant, and therefore should not take into account the
anticipated discontinuation of the subject asset – other willing buyers may want access to the asset under review and
may stand ready to purchase it. When the asset is then phased out in the aftermath of the combination, impairment
testing in accordance with IAS 36 ‘Impairment of Assets’ will result in an impairment loss that is sometimes recognised
almost immediately after the recognition of the intangible asset.
For similar reasons, synergies or other benefits that are available only to the specific acquirer should also be
excluded from fair value measurement. Depending on the actual circumstances it may often be concluded
that anticipated synergies may also be realised by another typical market participant. Typical examples
include cost savings from an expanded customer base or similar economies of scale. However, a careful
analysis of the underlying assumptions is necessary to ensure that buyer-specific intentions or synergies are
excluded from the fair value measurements of identifiable intangible assets. These buyer-specific benefits are
generally an element of goodwill.
14 Identifying and valuing intangibles under IFRS 3 2013: Section B
Highest and best use
When measuring fair value, the acquirer must take into account the asset’s highest and best use from the
perspective of the typical market participant. This entails considering the participant’s physical, legal and
financial abilities to use the asset in order to maximise the economic benefit generated (IFRS 13.28). Although
the buyer’s intention may be to discontinue use of the asset or to use it in a specified manner other than what
would generate the most economic benefit, these factors should not be considered in the determination.
Accordingly, an asset’s highest and best use may require that it be valued on a stand-alone basis or in
combination with other assets and liabilities that would be available to a participant (IFRS 13.31). In many
cases however, “…an entity’s current use of a non-financial asset is presumed to be its highest and best use
unless market or other factors suggest that a different use by market participants would maximise the value
of the asset” (IFRS 13.29).
Maximum use of observable market inputs
As noted above (and also as acknowledged in IAS 38), active market quotes are rarely available for intangible
assets. However, valuation techniques used to measure fair value should maximise the use of relevant
observable inputs and should minimise the use of unobservable inputs (IFRS 13.67) in order to achieve
the most reliable estimate of fair value. In the case of unobservable inputs, an entity should use the best
information available (IFRS 13.89), which may include the entity’s own data, recent market transactions and
practices in the industry of the acquired entity.
Income taxes (including tax amortisation benefits or TABs)
Typical market participants are usually subject to income taxation. Accordingly, economic benefits generated
by the utilisation of the asset in question are normally taxable and related expenditures are normally tax
deductible. The tax consequences of acquiring an asset will of course affect the amount a typical market
participant would pay for that asset. Some valuation methods directly incorporate the impact of tax on
fair value, while others may provide a pre-tax value or reflect a buyer-specific tax position. Whether special
attention is required to ensure inclusion of tax effects in the fair value estimate therefore depends on the data
on which the estimate is based:
•
in a market approach the underlying data is usually considered to reflect income tax effects and
additional adjustments are not usually necessary to incorporate tax effects into the estimate
income approach estimates are developed by considering the income stream generated by the
intangible asset under review, reduced by any related expenses. Therefore, an entity needs to consider
both the cost and benefits (if any) if the asset was recognised for tax purposes
fair value estimates using the cost approach may or may not require specific consideration of income
taxes. This mainly depends on whether the underlying data already reflects the effects of income taxation.
If a cost approach-based estimate is derived from cost data observable in the market place, then it may be
appropriate to conclude that all relevant tax effects are already reflected in the estimate. However, special
consideration may be necessary in other circumstances.
•
•
The impact on fair value of TABs requires specific attention. Intangible assets that are acquired in a separate
purchase are usually recognised in the purchaser’s tax balance sheet and/or tax return. Accordingly, they are
tax amortisable. The tax amortisation reduces the income taxes payable as a result of obtaining and using the
asset. Fair value estimates should reflect the tax benefits a typical market participant would be able to obtain
due to tax amortisation if the asset were purchased separately, even if it is actually acquired in the context
of a business combination. A TAB should therefore be added if typical market participants would obtain tax
amortisation, if this affects the amount they would be willing to pay and if the valuation technique applied
does not already take this into account.
Different methods to calculate TABs have been developed in practice and there is no universal consensus
on exactly how they should be estimated in the context of fair value measurement. Each method generally
calculates and discounts the hypothetical income tax savings that would arise as a result of tax amortisation
of the subject asset.
Identifying and valuing intangibles under IFRS 3 2013: Section B 15
Example B.3 – Calculation of TABs
On 1 January 2013, Entity A measures the fair value of an intangible asset using an income capitalisation method. The
present value of future cash flows attributable to the asset, which have already been reduced by an income tax charge,
have been determined at CU5,500. This estimate reflects an average income tax rate of 30% and an asset-specific
discount factor of 12%. The asset’s economic life is 3 years. In accordance with the applicable tax laws for typical
market participants, the intangible asset would be amortised for income tax purposes over a period of 5 years. A very
straightforward way to measure TABs on the basis of these assumptions is illustrated as follows:
Present value of future net cash flows less income taxes: CU 5,500
Amortisation
2013
2014
2015
2016
2017
Total
(1) Hypothetical tax amortisation expense
1,100
1,100
1,100
1,100
1,100 5,500
(2) Assumed tax benefit at 30%
330
330
330
330
330
tax rate [(1) x 30%]
(3) Discount factor at 12%
(4) Annual amortisation benefit
[(2) x (3)]
0.893
0.797
0.712
0.636
0.567
295
263
235
210
187 1,190
Indicative fair value including TABs
6,690
Without further refinement, the TAB element of the estimate would be determined at CU1,190 and on the basis of
the post-tax discounted cash flow measure of the intangible asset, fair value would equal CU5,500 + CU1,190 =
CU6,690. This approach, however, would not take into account the circularities of the TABs on the tax amortisation
amount itself – CU6,690 would not result in a hypothetical tax amortisation expense of CU1,100 per year as the
calculation above suggests. Further iterations are therefore often used to refine the calculation of the TAB. In a
second iteration, the ‘indicative fair value’ of CU6,690 would be used to re-calculate the TAB, followed by further
repetitions until the total tax amortisation expense equals post-tax net present value of the intangible asset plus its
TAB. In this example the TAB’s equilibrium is found after the 7th iteration at CU1,519. Fair value is therefore
determined at CU7,019 = CU5,500 + CU1,519.
Iteration
Post-tax discounted
Indicative fair value
Hypothetical tax
cash flows
(including TABS)
amortisation expense/year
1
2
3
4
5
6
7
5,500
5,500
5,500
5,500
5,500
5,500
5,500
5,500
6,690
6,946
7,003
7,014
7,018
7,019
1,100
1,138
1,289
1,401
1,403
1,404
1,404
TAB
1,190
1,446
1,503
1,514
1,518
1,519
1,519
In practice, these iterations may be processed more efficiently with an electronic spreadsheet. Alternatively, an annuity
formula will produce similar results:
TABs =
Post-tax discounted cash flows * (amortisation period / (amortisation period – annuity factor * tax rate) - 1)
Typically, the annuity factor would assume an ordinary annuity.
Regardless of the measurement method used, the TAB element of the fair value estimate should reflect the
following characteristics that would be reasonable to expect for a typical market participant:
• whether the particular asset is tax deductible or not
•
•
•
the period over which the subject asset may be amortised
the mode of amortisation for the asset (eg straight-line or other)
the average income tax rate.
16 Identifying and valuing intangibles under IFRS 3 2013: Section B
Amortisation periods
When calculating the TABs, the tax amortisation period is typically assumed to equal the useful economic life unless the
applicable jurisdiction’s tax law specifies otherwise. Section 197 of the US Internal Revenue Code, for example,
mandates a 15-year straight-line amortisation period for any intangible asset, regardless of whether it will actually be
used over a shorter or longer period of time. In practice, a 15-year amortisation period is therefore often assumed in the
United States when a typical market participant’s expectation of the TABs is estimated, even when its economic life is
considered to be indefinite. Other approaches, however, are acceptable to the extent that they are consistent with the
overall characteristics of the business combination and the related market.
To ensure consistency, the tax rate used to calculate the TABs is often equal to the assumed income tax rate
used for other valuation procedures within the same purchase price allocation. The asset’s economic life may
also be different from its tax amortisation period as established by law.
Multiple approaches to fair value measurement
The fair value of an intangible asset can many times be estimated using more than one of the approaches
explained above. It is sometimes preferable to use multiple techniques in order to narrow down the range
of fair values and to serve as a sense check. For example, a cost-based estimate of a readily replaceable
intangible asset may provide an upper limit for fair value, as a market participant will not pay more than cost
to replace or reproduce the asset. However, IFRS 13 emphasises the selection of the valuation technique
should “maximise the use of relevant observable inputs and minimise the use of unobservable inputs” (IFRS
13.67). Therefore, the acquirer should not ‘blend’ the results of different measures, but should rather select
the valuation approach that is based on the most observable inputs within the fair value hierarchy.
Example B.4 – Multiple approaches to fair value measurement
Background:
The acquirer in a business combination determines the fair value of an intangible asset using two approaches:
Income approach
Cost approach
Mean average of the two approaches
CU 1,000,000
CU 1,200,000
CU 1,100,000
At which amount should the acquirer record the intangible asset?
Analysis
The acquirer should not record the mean average or a similar blend. The acquirer should rather determine the measure
that takes into account as much observable market data as possible. This will often be the value arrived at under an
income approach, but sometimes a cost approach may also be justifiable.
Identifying and valuing intangibles under IFRS 3 2013: Section B 17
Specific IFRS 3 requirements
IFRS 3 sets out specific measurement requirements that deviate from normal for a few types of assets and
liabilities. These expectations include specific requirements on reacquired rights and acquired assets that are
immediately classified as held for sale.
2. Market approach methods
Market approach methods have limited practical application in estimating fair values of intangible assets.
Intangible assets tend not to be homogeneous and are traded on active markets only rarely (eg some
emissions trading certificates). Market approach methods are nonetheless discussed briefly below, mainly for
the sake of completeness.
2.1 Key inputs
Key inputs into market approach methods are very fact specific. Market data (quoted market prices and
observed transaction prices) used in fair value measurement should however always be assessed from
two perspectives. Firstly, prices are more relevant and persuasive if observed on a liquid and transparent
market. Data derived from a market that does not exhibit these qualities may not reflect assumptions that
willing and knowledgeable parties would consider in an arm’s length transaction. Secondly, to be useful
the price should relate to assets that are either identical to the asset in question, or sufficiently similar to
enable a meaningful comparison to be made. The effect on fair value of differences between the items
traded in the reference market and the intangible asset in question may be very significant and should be
capable of reasonable estimation.
Exceptions to the rule: where market data may be available
Active markets for intangible assets are very uncommon, although this may happen. For example, in some jurisdictions,
an active market may exist for freely transferable:
•
taxi licenses
• fishing licenses
• production quotas (IAS 38.78).
Liquid and transparent markets
Market data is most persuasive when derived from a market with a reasonable level of liquidity and
transparency. Liquidity exists where markets are regularly accessed and used by a wide range of willing
buyers and sellers to transact items that are similar to the intangible asset under review. In less liquid
markets, the observed transaction prices might be less representative of the price a typical market
participant would be willing to pay. Transparency is required to assure that market prices are observable
by other market participants.
Compatibility of market data
The validity of the market approach depends upon the availability of sufficiently comparable transactions.
Market data may be compatible with the intangible asset where the asset is very similar in nature and is
used in a similar way. Factors to consider include whether it has the same functionalities and is used in a
similar region or market. Where market data is available for similar (but not identical) assets, an assessment
of its suitability as a basis for estimated fair value is required. The key question is whether the available data
provides the best available evidence (or inputs) as to the price typical market participants would pay for the
asset in question.
2.2 Sales transactions comparison method
Fair value measurement under the sales transactions comparison method requires information on sales
transactions for similar assets. Differences between the asset under review and assets for which transaction
price data is available need to be quantified and incorporated into the fair value estimate.
The fair value of the asset in question is assessed in a benchmarking-type exercise by estimating its fair
value relative to observed transaction prices of similar intangible assets. The sales transactions comparison
method may therefore require similar procedures to the ones described under the replacement cost method
(see Section B.3.3) or the relief-from-royalty method (see Section B.4.2). Adjustments for income taxes are
usually not necessary as the transaction prices should reflect all the factors that are taken into account by
market participants in setting those prices.
18 Identifying and valuing intangibles under IFRS 3 2013: Section B
2.3 Methods using market multiples
Methods using market multiples may sometimes be more appropriate than the sales comparison method,
especially where market prices can be demonstrated to correlate closely to financial metrics relating to the
asset. Examples of such correlations might include:
• price to cash flow
• price to earnings
• price to revenue.
In some cases market prices might correlate with non-financial metrics as well or instead. A non-financial
metric is often industry-specific and should normally be used only if widely applied in pricing assets in that
industry. Judgment is necessary to assess the extent to which a typical market participant would take the
non-financial or financial metric into consideration in making a pricing decision.
3. Cost approach methods
The most commonly used cost approach methods are the reproduction cost method and the replacement
cost method. In practice, methods that are based on the cost approach are less frequently accepted than
income approach methods because cost measures are considered less representative of future economic
benefits (and hence fair value) than anticipated income streams.
Nevertheless, some assets are commonly measured at cost to replace or reproduce, especially where
these can be duplicated (at least in theory) by a typical market participant. Cost approach methods are also
sometimes considered in addition to fair value measurement under the income or the market approach as
a means of validating the other estimate – historical or current cost to replace or reproduce is often seen as
an upper limit for fair value, as no prudent market participant would pay more than it would cost to create a
comparable asset.
3.1 Key inputs
Cost approach methods try to approximate acquisition date fair value by determining current cost.
Factors commonly considered in applying the cost approach
• prices payable for known comparable or alternative assets with similar characteristics and functionalities that may be
available for purchasing and their cost (especially under the replacement cost method)
• historical cost to generate or acquire the asset and price indices for the relevant industry of the intangible asset
in question
•
functional deterioration
• economic obsolescence
• opportunity costs (eg representing the ‘time out of the market’ if the acquirer were to reproduce or replace the asset
under review)
• effects from income taxation (including TABs) where these are not already reflected in the cost data used for the fair
value estimate.
In many cases, an external estimate of the current cost to replace or reproduce an intangible asset will not be
readily available. Fair value estimates using cost approach methods therefore often rely on past costs incurred
by the acquiree. This raises an important question: are costs incurred by the acquiree in developing the
asset consistent with what a typical market participant would pay for the asset? In practice, this may require
professional judgment in areas such as:
• early state development costs – would market participants consider incurring the same early state
development costs given the conditions at the date of acquisition?
• overhead costs – would another party incur the same cost and thus reflect that in its estimate of
fair value?
• sunk costs and ineffective expenditures – would the typical market participant incorporate the risk of
unnecessary expenditures in an objective assessment of fair value assuming a reproduction of the asset?
Identifying and valuing intangibles under IFRS 3 2013: Section B 19
The state of obsolescence or impairment of the asset subject to development is another input used in
the cost approach. Often an asset may be operationally functional but has lost value due to new products
or services that are more efficient or operationally superior. The software industry, for example, has many
examples of product obsolescence and impairment – for example, historical cost incurred to develop tailor-
made software may have been higher due to specific original features in the software that are no longer
required at the acquisition date. Physical deterioration however is usually not taken into account when
estimating the fair value of intangible assets.
3.2 Reproduction cost method
This method requires an estimate of the cost incurred to reproduce the intangible asset in its acquisition
date condition. It can be useful as an estimate of fair value for an intangible asset that has been purposely
developed by the acquired entity itself (for example in-house developed software).
The reproduction cost method estimates all the costs a typical market participant would incur to generate
an exact replica of the intangible asset in the specific context of the acquired business. This would typically
include directly attributable cost (wages, cost of material and so on) as well as the ‘cost of being out of the
market’ – representing the additional cost incurred or income lost during the time until the asset under
review is ready for its intended use. Depending on the significance of the time it would take to reproduce, it
may be appropriate to discount these additional elements of cost.
Reproduction cost does not take into account actual market demand for the asset. Hence, the
reproduction cost estimate does not take into consideration whether a third party would actually
want the exact replica of the asset, but only whether different characteristics are still required as at
the date of acquisition.
Reproduction cost is of course itself an estimate. For practical purposes, the actual cost incurred by the
acquiree is likely to be the best starting point for making this estimate. However, some intangible assets
are created by the actions of the acquiree over time but not as part of a discrete development project.
Customer relationships are for example created and enhanced continually through ongoing interactions with
customers. The costs incurred in developing such assets are usually not monitored separately. In the absence
of information on actual costs incurred and any other reliable basis to estimate reproduction cost, alternative
fair value estimation methods should be given priority.
Example B.5 – Internally generated software (part i)
Internally generated software has been detected in the course of a business combination at the candy manufacturing
business ‘TARGET’. The software, which was tailor-made for TARGET a few years prior to the combination, supports
TARGET’s quality control in its gummy bear factory. The software monitors the weight and size of the gummy bears as
well as whether they are blue, yellow or red.
No comparable software solution has been identified on the market and the reproduction cost method has been
determined as the most appropriate way to establish its fair value. An analysis of the original development plan shows
the hours actually spent when the software was developed a few years ago.
Module
Description
Hours
Cost of module
A Platform
Serves as a basis for all other modules
B Measurement module
Monitors weight and size of output and
C Blue-detection
D Yellow-detection
E Red-detection
Historical cost of software
determines waste of production
Detects blue gummy bears
Detects yellow gummy bears
Detects red gummy bears
250
180
50
40
40
(CUs)
25,000
18,000
5,000
4,000
4,000
56,000
Except for the ‘blue-detection’ module, an analysis of the acquired business shows that the software would continue to
be needed in its current form to further support quality controls of TARGET. The acquiree, however, ceased to make blue
gummy bears a few years ago in reaction to slow sales. As at the acquisition date, the candy industry is virtually
dominated by yellow or red gummy bears.
20 Identifying and valuing intangibles under IFRS 3 2013: Section B
Example B.6 – Internally generated software (part ii)
A further analysis shows that current programming costs have increased to 150 CU/hour (original hourly cost was
CU100) and due to new debugging tools available, the platform would probably take only 220 hours to reconstruct.
Further obsolescence or technical depreciation was not identified. However, it is estimated that the time required to
reproduce the software would cause a quality loss that would create waste in excess of current levels amounting to
CU8,000. Based on these considerations at the acquisition date, cost of reproduction is estimated as follows:
Module
Description
Hours
Cost of module
A Platform
Serves as a basis for all other modules
B Measurement module
Monitors weight and size of output and
D Yellow-detection
E Red-detection
Historical cost of software
determines waste of production
Detects yellow gummy bears
Detects red gummy bears
Excess waste until quality control software
is available
220
180
40
40
–
(CUs)
33,000
27,000
6,000
6,000
8,000
80,000
TABs are not specifically considered in this example. All cost-based inputs into the estimation are considered to reflect all
income tax effects a typical market participant would take into consideration in estimating the reproduction cost of
the software.
The reproduction cost method is also widely used to measure the acquiree’s assembled workforce. While
the workforce may not be recognised as an intangible asset in principle (IAS 38.15, see also Section A.3), it
is an important input in measuring other intangible assets under the income approach. Hence, fair value of
the assembled workforce is commonly estimated in business combinations to establish a ‘contributory asset
charge’, a concept that is discussed more fully in the context of income approach methods in Section B.4.4.
Some of the aspects to take into account in determining the cost to (theoretically) duplicate the current
workforce are:
• recruiting cost (cost of hiring, relocation, etc)
•
•
training cost
time to achieve full productivity or the degree of lost productivity.
The fair value of an assembled workforce is usually determined by reference to specific groups of
employees that are for example distinguished on the basis of their skills, level of management and
geographic location. The following example gives a basic idea of how to apply the reproduction cost
method to an assembled workforce.
Identifying and valuing intangibles under IFRS 3 2013: Section B 21
Example B.7 – Assembled workforce (part i)
TARGET’s customer relationship intangible asset is measured using an income approach. One of the key inputs is the
cost otherwise incurred by a typical market participant in the absence of TARGET’s assembled workforce. To determine
the acquisition date fair value of the assembled workforce, the workforce is analysed as follows:
Group
Number of Average annual Average recruiting
Training cost Time to full
employees compensation
cost
(CU/person) productivity
(CU/person)
(CU/person)
(months)
Senior management
Product developers
Marketing personnel
Administration
Other support staff
5
10
25
15
5
200,000
130,000
100,000
70,000
50,000
100% of annual salary
20,000
50,000 ‘flat fee’
None
None
None
5,000
5,000
5,000
4,000
6
10
3
1
–
TARGET assumes that 50% of productivity is lost during the initial period of employment. Based on these assumptions,
the cost of the assembled senior management could be estimated at CU1,350,000 – cost to train (20,000), cost to
recruit (200,000) and assumed lost productivity of 50% during the initial 6 month period, which equates to cost of 25%
of the average annual compensation (6/12 x 50% x 200,000), calculated for the 5 employees.
In other words, reproduction cost for TARGET’s assembled workforce would take into account the cost to recruit and
train as well as lost productivity during the initial phase of employment. The cost to reproduce TARGET’s assembled
workforce as a whole, based on these assumptions and this basic measurement method is estimated as follows:
Group
Average
Training
Lost
Average annual Number of Cost to
recruiting
cost
productivity compensation
employees reproduce
cost
(CU/person) (CU/person) (CU/person)
(CU/person)
Senior management 200,000
20,000
Product developers
50,000
Marketing personnel
Administration
Other support staff
–
–
–
5,000
5,000
5,000
4,000
25%
42%
13%
4%
0%
Total cost to reproduce assembled workforce
200,000
130,000
100,000
70,000
50,000
5
10
25
15
5
(CU total/
group)
1,350,000
1,096,000
450,000
117,000
20,000
3,033,000
Part ii of the example illustrates how TABs would usually be incorporated into a cost approach-based
estimate of an assembled workforce’s fair value, when this is considered necessary.
22 Identifying and valuing intangibles under IFRS 3 2013: Section B
Example B.8 – Assembled workforce (part ii – tax effects)
The data used to estimate the total cost to reproduce the assembled workforce is not considered to reflect income tax
considerations that a typical market participant would take into account. The initial cost measure is therefore reduced by
average income taxes of 30% and TABs are added.
To establish TABs, it is assumed that in a separate acquisition, the intangible asset would usually be amortised for tax
purposes over a 15 year period. It is also expected that the income tax rate remains steady and the appropriate
discount rate is determined at 17.0% (see Section B.4.1 for a discussion of asset-specific discount rates).
Total cost to reproduce assembled workforce before taxes
Income tax (30%)
Tax amortisation benefit
Indicative value of workforce
The calculation of TABs in this example may be illustrated as follows:
CUs
3,033,000
(909,900)
226,076
2,349,176
Amortisation Period (years)
1
2
3
Amortisation per year
141.54
141.54
141.54
Tax rate
Tax Benefit per year
Discount rate
Discount factor
30%
42
17%
30%
42
17%
30%
42 => year
17%
4- 13
0.855
0.731
0.624
Present value of TABs per year
36.3
31.0
26.5
PV Sum (pre-tax)
TAB Value (post-tax)
226.1
253.0
14
15
141.54
141.54
30%
42
17%
30%
42
17%
0.111
0.095
4.7
4.0
3.3 Replacement cost method
Replacement cost represents what it would cost today to acquire a substitute asset of comparable utility. The
replacement cost method is especially useful for purchased intangibles such as off-the-shelf software and
similar licenses. In such cases, an observable market price is available for a substitute asset even if that price
does not meet the conditions to be considered a quoted price in an active market. The method is similar to
the sales comparison method discussed above in that it is based on actual transaction prices for sufficiently
similar assets. If a replacement cost is obtained for a comparable but not identical asset, adjustments may be
required for factors such as differences in technology, capability, functionality and age.
Example B.9 – Business software
A business software application is identified in the course of a business combination. The software, version 4.0 was
acquired by the target business 3 years prior to the combination and is used widely for managerial accounting and
financial reporting of the business. It has been updated regularly.
The software manufacturer has ceased to sell version 4.0 but currently offers version 5.5, which incorporates all
updates of previous software versions. An analysis of the two different versions shows that the new version is mainly
faster and more user friendly, but otherwise has the same features and functionality. A cost analysis compares version
4.0 to a replacement with version 5.5 as follows:
Cost element
Cost to acquire the license
Installation
Update A
Update B
Total
Version 4.0 (CU)
Version 5.5 (CU)
90,000
7,000
3,000
5,000
105,000
10,000
–
–
105,000
115,000
Identifying and valuing intangibles under IFRS 3 2013: Section B 23
In this scenario, cost to replace version 4.0 would range somewhere between CU105,000 and CU115,000.
Professional judgment is required to determine to what extent version 4.0 is less valuable than version 5.5, given its
reduced speed and user friendliness. On the other hand, the historical cost of CU105,000 would need to be assessed
for any changes due to inflation, etc. to estimate the acquisition date fair value of this intangible software asset.
Income tax affects are considered to be appropriately reflected in the valuation since the cost approach estimate is
broadly based on market observations.
4. Income approach methods
Fair value estimates using the income approach provide a value based on the cash flows an individual
intangible asset is expected to generate. These income streams are discounted and also usually adjusted
for the effects of taxation. The key inputs used in these methods are described in the next sub-section.
Subsequent sub-sections will explain the income approach methods most commonly used in practice:
•
•
•
the relief-from-royalty method (Section B.4.2)
the comparative income differential method (Section B.4.3)
the multi-period earnings excess method (Section B.4.4).
4.1 Key inputs
Income approach methods estimate the fair value of an intangible asset by reference to the capitalised value
of income, cash flows or cost savings that could hypothetically be earned, achieved or otherwise obtained by
typical market participants. These methods therefore depend on prospective financial information (PFI) that
represents the benefits expected from a specific asset. Estimating the appropriate discount rate and income
taxes also require special consideration.
Assessing key inputs of income approach methods
•
is the PFI underlying the valuation unbiased and consistent with the assumptions that market participants
would make?
• do the PFI income streams incorporate expected income tax payments?
• does the resulting fair value estimate appropriately reflect the economic life of the intangible asset?
•
if a weighted average cost of capital (WACC) is used to discount the cash flows, does it reflect a capital structure
and required return on equity that is usual for the industry rather than parameters that are specific to the
acquired business?
• do asset-specific discount rates reasonably reflect the risk profile of the intangible asset?
• does the asset’s fair value reflect tax amortisation benefits that would be available to market participants?
Complex mathematical
valuation methods, such
as real option pricing
models and Monte Carlo
simulations are not
covered in this Guide.
The methods discussed
in this Guide represent
some of the valuation
methods commonly
used in practice.
Other and especially
more mathematically
advanced and complex
methods may also
be appropriate for
estimating an intangible
asset’s fair value.
Prospective financial information (PFI)
The financial estimates on which income approach methods are based are referred to hereafter as PFI.
Preparing and reviewing suitable PFI is a complex matter and depends on the facts and circumstances of
the intangible asset in question as well as the business and the industry it belongs to. In theory, the PFI used
in the measurement process should be based on the expectations of the market participants, which implies
the need to make assumptions about other participants’ assumptions. In practice, however, the budget
and forecasts of the acquiree at the acquisition date are likely to be the best source (or starting point) for
the exercise, unless they are demonstrably out of line with estimates that market participants would use to
price the asset. The same principle applies to PFI that the acquirer may have applied in the course of the due
diligence process. Other characteristics to look out for are:
•
the PFI should normally represent an unbiased estimate for future development at the date of acquisition,
based on the best information available at the date of acquisition and consistent with recent experience.
The estimate should take reasonable consideration of industry-specific outlooks as well as information
relating specifically to the intangible asset
the data underlying the valuation should generally set out detailed expectations for a specific budget
forecast period, commonly known as the discrete projection period, as well as reasonable assumptions for
financial developments which are anticipated beyond the planning horizon
•
24 Identifying and valuing intangibles under IFRS 3 2013: Section B
•
the PFI should include detailed projections of key figures of operating performance (for example
projections of sales as well as gross, operating and net results after tax) and post-tax cash flow projections
of the acquired entity that exclude financing costs. Estimates about the level of working capital, capital
employed and capital expenditure are also necessary. More details may be needed due to the actual
characteristics of the particular intangible asset.
Fair value is determined from the perspective of a typical market participant. Enhancements of the
business that are generally available to market participants may therefore be reflected in the PFI. Effects of
specific post-combination strategies of the acquirer that a typical market participant would not take into
consideration should however be eliminated from the PFI.
Examples of specific benefits or expenditures are:
• cost savings due to synergies that would not be available to another market participant
• unusually high overhead costs that are specific to the combined group
•
income tax considerations that create either a benefit or a disadvantage for the combined group and that
are specific to the buyer’s circumstances – these effects would instead usually be reflected in accounting
for deferred taxes.
PFI will usually be provided by management for a period of at least three to five years, followed by projections
for subsequent periods. The growth rate used in the projections is often steady or declining and does not
exceed the usual growth rate for the products, industries, countries or markets relevant to the business under
review. Exceptional growth rates may nevertheless be appropriate if the acquired business is for example
active in high growth sectors (sometimes for example found in high tech industries).
Economic life
The valuation should not assume income for a period longer than the asset’s economic life (the period over
which it will generate income). The fair value of an asset measured under the income approach increases with
its economic life, making this an important input.
Mismatch of economic life assumed for fair value estimates and amortisation rules of IAS 38
Intangible assets that are based on legal or contractual rights usually have a limited life, which may or may not be
extended. A typical market participant would take into account the likelihood of any potential extensions in determining
acquisition date fair value of the asset.
This may create a mismatch with the useful life that is used to subsequently amortise that intangible asset. To
determine the amortisation period of an intangible asset, IAS 38 requires an estimate of its useful life. The standard
however also mandates that the “useful life that arises from contractual or other legal rights shall not exceed the period
of the contractual or other legal rights” (IAS 38.94). The possibility of a renewal of the right may only be reflected in the
asset’s useful life if the renewal is possible without significant cost. If the renewal is contingent upon the consent of a
third party, evidence that the third party will give its consent is required to support an amortisation period that exceeds
the asset’s legal life (IAS 38.96).
This mismatch will not arise with a reacquired right recognised as an intangible asset in a business combination. The
useful life of such an asset is limited to the remaining contractual period excluding potential renewal periods (IAS 38.94).
Similarly, the value of the reacquired right is measured on the basis of the remaining contractual term excluding potential
renewal periods (IFRS 3.29). This is an exception to the normal fair value measurement requirements for assets acquired
in a business combination under IFRS 3 (see Section C.4.1).
The economic life of most intangible assets is finite and is normally reasonably estimable. In some
circumstances, however, a limit to the period over which the asset is expected to generate economic
benefits for the entity may not be foreseeable. The intangible asset is then considered to have an
‘indefinite’ useful life.
Identifying and valuing intangibles under IFRS 3 2013: Section B 25
In practice, indefinite useful lives are not the norm. A full assessment of the economic characteristics of
the intangible asset is generally required to demonstrate the limits of an asset’s economic life (or the lack
thereof). Indicators of the upper limit of an asset’s economic life will sometimes result from legal constraints.
Patents, for example, usually provide exclusive use of a technology for a limited period (in many countries 20
years from patent registration), after which patent protection is lost and income streams may erode rapidly.
On the other hand, legal protection for intangible assets such as trademarks may often be extended without
significant legal or economic constraints. A typical market participant would therefore factor in the possibility
of extending the legal life for further periods when pricing the intangible asset, so that its economic life may
be substantially longer than its ‘current legal life’. This may specifically apply to trademarks that represent a
company brand – economically, these intangible assets often exist for as long as the underlying business.
Some of the aspects to take into account when estimating the economic life of an intangible asset can be
legal, regulatory and contractual provisions that may limit the life or enable renewal and extension
life cycles of related products or marketing strategies
summarised as follows:
•
•
• expected use and typical patterns of depreciation in the value of similar assets
• expected technical, commercial or other types of obsolescence
• expected actions by competitors or potential competitors
• economic life of other assets used in conjunction with the intangible asset to generate income.
Again, the perspective of the typical market participant should be assumed when assessing an intangible
asset’s economic life. Characteristics that are specific to the actual buyer – such as the intention to discontinue
the asset under review – are therefore disregarded in this assessment.
Weighted Average Cost of Capital (WACC)
Income approach methods generally require discount rates to estimate fair value. As a starting point for
estimating asset-specific discount rates (which are discussed further below), the industry average Weighted
Average Cost of Capital (WACC) is usually used in practice. The basic concept of the WACC is that a business
will finance its assets with a combination of debt and equity and that a required minimum return can be
established for each source of capital. The average of these considerations would typically be the rate of
return a typical market participant would expect on an investment in the industry. The actual calculation of
the WACC may be illustrated as follows:
•
the weight factors (debt (D) and equity (E) as a fraction of the overall funding of the business (D+E)) usually
reflect financing structures that are typical for the industry of the business under review. The entity’s
actual or anticipated financing structure may give an indication for this input, but does not necessarily
prescribe the weight factors
the income tax rate (Tc) used in the WACC should reflect the income tax rate that is applicable to interest
payments on debt by a hypothetical entity that is active in the same industry as the subject business. This
rate normally corresponds to the income tax rates used in the PFI
the return required for debt (rdebt) should reflect the interest rates typically available to similar businesses
as the one under review. This input factor usually can be determined on the basis of readily observable
market data by reference to returns required for debt issued by business with similar credit risk profiles
the return required by a typical market participant (requity) is usually determined on the basis of the Capital
Asset Pricing Model (CAPM). The CAPM takes into account two factors: the return on an investment that
is virtually risk-free (such as certain government bonds) and the market risk premium that would be
required by an investor in the acquired business
•
•
•
• additional risk premiums (or ARP), to the extent not captured within requity, are sometimes added to reflect
risk that is typical for businesses similar to the one under review. Examples are mark-ups for fairly young
companies, very competitive industries and dynamic markets to reflect the risk that they are more likely to
become financially distressed
• another possible modification is a small business premium (SP). The small business premium takes into
account the tendency for smaller businesses to typically be subject to higher capital costs than medium-
sized and large businesses.
26 Identifying and valuing intangibles under IFRS 3 2013: Section B
Small business premiums – variances in use
Globally, there is diversity in practice for whether the use of small business premiums is appropriate. While valuation
industry standards of some countries, such as in the US, would support the use of SP’s (and would expect one to be
reflected when applicable), industry standards in other countries, such as Germany, would not find their use to be
appropriate. Therefore, although the reporting framework (eg IFRS) could be the same in two geographic locations, the
local valuation practices that are applied in the fair value measurement could result in different models and values being
reached, where market participants take account of different factors according to the geographic region in which they
are based. Thus, local valuation industry practices should be assessed to ensure the results are appropriate for the
specific circumstances.
All of the WACC’s underlying assumptions should be reasonable and supported by market data as far as
possible. Some elements of the WACC are therefore based on the results of detailed market research. Other
elements, such as business premiums and additional risk premiums generally rely more on professional
judgment (which, in turn, is sometimes backed by research).
Depending on the complexity of the acquired business, it may be necessary to determine individual
WACC figures for distinct parts of the entity – referred to as ‘business units’, ‘divisions’ or (in IFRS terms)
‘operating segments’ or ‘cash generating units’. This is commonly seen in practice where the acquired
business is active in different geographic areas or in industries with different exposures to risk. In such a
scenario, the starting point for determining the specific discount rate to be used in measuring intangible
assets under the income capitalisation approach should of course be the WACC of the distinct part of the
acquired entity that the individual asset belongs to.
Example B.10 – Determining whether multiple WACC’s are necessary
An entity acquires a business that is organised into two strong segments: logistic services (segment A) and freight
services (segment B). Since segment A focuses exclusively on organising the transport of goods whereas segment B
provides freight services, it is determined that the two segments have different risk characteristics. As a result, fair value
estimates in segment A are based on a different WACC than estimates for assets used by segment B.
Asset-specific discount rates
The discount rate used to value an individual asset should reflect the return that market participants would
demand for bearing the risks inherent in the asset. Accordingly, the use of a ‘flat’ discount rate for every asset
valued under the income approach is usually not appropriate. Different assets generally exhibit different risk
profiles and discount rates therefore need to be adjusted to reflect the risks specific to a particular asset.
The WACC provides a point of reference in estimating asset-specific discount rates. An assessment of the
economic risk profile of each asset provides an indication of whether it is riskier or less risky than the business
as a whole and in comparison to other assets.
Some intangible assets are often considered riskier than the business as a whole. As a consequence,
discount factors used to estimate their fair values tend to be higher than the WACC. An in-process research
and development (IPR&D) intangible asset may for example be regarded as riskier than a well-established
trademark intangible asset. The IPR&D intangible asset should therefore be measured using a higher asset-
specific discount rate than the trademark. The risk profile of the trademark may in turn be similar to the risk
profile of the entity it belongs to. It may therefore be appropriate to choose an asset-specific discount rate of
the trademark that is close to the WACC.
The certainty with which an asset’s associated cash flows can be tangibly identified and are realisable
often has an inverse relationship with its risk profile, as illustrated in the table above. The relationship of
the economic risk between assets and the business as a whole significantly depends on the industry and
specific circumstances.
Different discount
rates are required
for intangible assets
with different risk
characteristics.
Identifying and valuing intangibles under IFRS 3 2013: Section B 27
Risk profile of intangible assets
i
A
s
s
o
c
a
t
e
d
r
i
s
k
Goodwill
IPR&D
Customer lists and relationships
Trade secrets and processes
Unpatented technology
Copyrights
Trademarks
Patents
Order or production backlog
e
r
u
t
a
n
e
b
g
n
a
T
i
l
There are no set rules as to how exactly asset-specific discount rates are determined, but two
different schools of thought can be observed in practice to determine the additional/reduced risk of the
intangible asset:
1. as a risk premium to the WACC, that can be positive (riskier than the business) or negative (less risky than
the business). The percentage to be added or subtracted from the WACC should appear reasonable and
logical.
2. adjust the debt/equity ratio in the WACC to reflect whether the intangible asset would usually be more
likely to be funded with equity (riskier) or debt (less risky). The adjustment of the weight factors in the
WACC formula may be supported to a certain extent by market observations.
Example B.11 – Adjustment of the debt/equity ratio to determine asset-specific discount rates
In a business combination, the WACC for TARGET has been determined at 9.9% using the following assumptions:
D/D+E = 60% rdebt = 6% Tc = 30%
E/D+E = 40% requity = 18.5%
WACC = 60% x (1-30%) x 6% + 40% x 18.5% = 9.9%
The entity has identified an IPR&D project that is expected to require about 2 years to complete before any revenue can
be expected from resulting products. Market research shows that similar projects are more likely to be financed with
equity, and a debt/equity ratio of 5% debt to 95% equity would be expected if a typical market participant focused its
activities just on this project. Based on this information, the discount rate specific for the IPR&D project, or WACCIPR&D
is estimated at 17.9%:
WACCIPR&D = 5% x (1-30%) x 6% + 95% x 18.5% = 17.8%
Alternatively, the entity could have added a risk premium to the WACC that is estimated to be appropriate based on the
economic characteristics of the intangible asset.
Despite the ‘grey area’ in estimating asset-specific discount rates, the overall process should generally appear
reasonable in the context of the return required for the different groups of assets acquired in the business
combination. As the acquired assets as a whole are required to earn on average a rate of return that is equal
to the WACC, the weighted average of the returns implied or used for the valuation of the individual assets
should roughly equal the WACC. In practice, this procedure is sometimes referred to as the ‘return test’, which
is illustrated in the next example.
28 Identifying and valuing intangibles under IFRS 3 2013: Section B
Example B.12 – Return test
The fair value of TARGET’s assets have been tentatively determined. For example, the specific discount rate for
TARGET’s IPR&D project has been estimated at 17.9% (see previous example). To assess whether the asset-specific
discount rates may be considered reasonable, a required rate of return has been estimated for all of TARGET’s assets.
The tentative fair values and their specific rates of return are illustrated as follows:
Asset class
Fair value (CU) Value in % of Implied required
Weighted
total assets
return/discount rate average
Working capital
Fixed assets
Trademark “TARGET”
IPR&D project
Assembled workforce (part of goodwill)
9,500
17,500
17,500
6,000
7,000
Goodwill (exclusive of assembled workforce)
6,000
Total
63,500
15.0%
27.6%
27.6%
9.4%
11.0%
9.4%
100%
4.5%
6.3%
10.0%
17.9%
17.0%
18.5%
0.7%
1.7%
2.8%
1.7%
1.9%
1.7%
Implied WACC
10.5%
The implied WACC of 10.5% seems reasonable when compared to TARGET’s WACC of 9.9% (see previous example). The
analysis, however, might require a further review. It may for example be necessary to further analyse whether a rate of
return of 10% is reasonable for the TARGET trademark or whether it is plausible that the implied required rate of return
for the assembled workforce is lower than the one assumed for goodwill. This will of course depend on the actual facts
and circumstances of the transaction.
The previous examples illustrate the extent of judgment involved in estimating the WACC of the business
as a whole as well as discount rates specific to individual intangible assets. Assessing whether these key
assumptions have been estimated appropriately will therefore also require judgment and will not be precise
by any means. While it is generally desirable to implement market observations into these considerations as
much as possible, a few aspects of the ‘return test’ should be kept in mind:
•
the return test requires a tentative measure of fair value for all assets of the acquired business. In other
words, the discount rates need to be estimated and an indicative or tentative fair value measurement is
required before each discount rate can be assessed in context
further iterations to estimate reasonable discount rates may therefore be necessary. Due to many
interdependencies in measuring fair value, eg when using the multi-period earnings excess method (see
Section B.4.4), a change in discount rates for a particular asset may trigger further adjustments in the
relative fair value of other assets
the return test allows only a relative assessment of individual discount rates. It will put into context the
individual asset’s rate of return relative to other assets of the acquired business. The rate of return on
goodwill is sometimes misused in practice to make the implied WACC appear reasonable. Very high or
low discount rates attributed to goodwill should therefore always be reflected against discount rates
attributed to other assets to assess their reasonableness.
•
•
Tax amortisation benefits (TABs)
Fair value measurement under the income approach is usually based on PFI that reflects cash outflows net
of income taxes. The PFI used often does not reflect the hypothetical benefit from amortising the intangible
asset for tax purposes (because the actual acquirer may not obtain any such benefit).
TABs are therefore usually specifically incorporated into fair value measurements that are based on
income capitalisation. It is common practice to calculate the present value of the TABs using the discount
rate specific to the underlying asset, ie the intangible asset in question. However, depending on the risk
characteristics of the amortisation benefit, a higher or lower discount rate may be more appropriate to
estimate the fair value of the TAB.
Identifying and valuing intangibles under IFRS 3 2013: Section B 29
4.2 Relief-from-royalty method
The relief-from-royalty method (sometimes referred to as the ‘royalty savings method’) is frequently used for
intangible assets that are legally protected and which could (in theory at least) be licensed to or from a third
party. Patents and trademarks are examples of intangible assets that are commonly valued under the relief-
from-royalty method.
The relief-from-royalty method values the intangible asset by reference to the amount of royalty the
acquirer would have had to pay in an arm’s length licensing arrangement to secure access to the same rights.
The key input into this method is the ‘royalty rate’, which is then applied to the ‘royalty base’ to estimate the
amount of theoretical royalty payments. This royalty stream, which the owner does not have to pay since the
intangible asset is already owned, is discounted.
Estimating the royalty rate
Actual licensing agreements for the same or similar assets generally provide the best basis for determining an
appropriate royalty rate. Arm’s length licensing agreements between the acquiree and a third party regarding
identical or similar intangible assets should therefore be considered.
Royalty rates are usually estimated on the basis of information available for recent market transactions. In
the absence of an actual licensing agreement for the subject asset, samples of ‘benchmark royalty rates’ for
similar intangible assets or comparable licensing arrangements may be found in royalty databases available
on the internet, valuation periodicals or similar sources. Such publicly available data may provide further
insights into how a typical market participant would estimate royalties for the intangible asset.
Unfortunately fully compatible royalty rates are hard to find in practice. In selecting benchmark royalty
rates, some of the following characteristics of the intangible asset under review and the market transactions it
is compared against should be considered:
• where and how the asset is expected to generate future economic benefits, for example in the form of
•
•
•
additional income or reduced costs including the life cycle of the intangible asset under review compared
to intangible assets for which sample royalty rates are available
the industry in which the asset is used and whether specific industry conditions may provide insights into
whether royalties in a given segment, asset class or area of technology are usually relatively high or low in
comparison to the industry average return on investment. Industry conditions may also take the form of
‘rules of thumb’ that are for instance used for profit sharing agreements
the value of a hypothetical license is likely to increase with the level of exclusivity of the underlying
intangible asset. A license may for example be granted exclusively for a geographic area or industry
it is also necessary to analyse ‘technical differences’ between royalty rates that are observable in the
market place. Some royalty rates may reflect underlying cost sharing agreements such as for related
research and development, legal protection, advertising or other marketing expenditures – whether or
not a licensee has to participate in marketing campaigns and hence incur additional expenditures may
substantially affect the license fee that is observable in the market place. Differences in payment schemes,
such as upfront, lump-sum or continuous royalties from the licensee or a combination thereof are also
frequently observed and should be taken account of. The royalty base may also differ – marketing-related
intangible assets such as trademarks are often based on the sales volume while other royalty rates may
apply to measures of gross margins.
Royalty rates used to
determine fair value
need to reflect an
appropriate estimate
which is based on
the best information
available on
acquisition date.
30 Identifying and valuing intangibles under IFRS 3 2013: Section B
Example B.13 – Estimation of a royalty rate based on observable market data
Extract from a hypothetical valuation report:
‘We looked to the marketplace to find license agreements on similar trademarks and trade names to help determine an
appropriate royalty rate. We obtained our guideline transactions from the PerfectRoyalties database1. Our search of
PerfectRoyalties resulted in 15 license transactions for trademarks within the microelectronic component sector, 4 of
which we determined were most comparable to the subject trademark. These transactions may be summarised
as follows:
Trademark
Subject
A
B
C
D
Market
position
Medium
Strong
Strong
Weak
Medium
Geographic
coverage
Multiple implicit in Subject brand multiple
transaction
higher or lower than
(% of revenue)
comparable
Europe
Europe
Russia
Japan, Taiwan
Americas, Europe
N/A
1.4
1.1
0.4
1.2
N/A
Higher
Similar
Significantly lower
Similar
Based upon this data and other empirical evidence, it is our opinion that the appropriate royalty rate associated with the
license of this trademark is 1.0 percent of revenue. This royalty reflects the level of recognition relative to the
trademarks in the transactions, and the recognition of the acquired business versus its competitors, based on trademark
recognition in the marketplace.’
Calculation methodology
The actual calculations in a relief-from-royalty estimate are fact specific. However, once the appropriate
royalty rate has been estimated, the process of estimating fair value using the relief-from-royalty method is
broadly as follows:
1. the estimated income stream or ‘royalty base’ that is attributable to the intangible asset is identified and
usually derived from the prospective financial information (PFI) of the acquired entity. The estimated
income stream is represented by a projection of net sales over the economic life of the intangible
asset less appropriate expenses. Income tax cash flows usually reduce the income stream, but further
expenditures may also have to be incorporated into the PFI where these are implicit in the royalty rate
estimate (eg marketing or R&D expenditures, sometimes also legal expenses). Care must be taken in order
to exclude buyer-specific synergies from the PFI
2. the future royalty payments the acquirer hypothetically saves due to ownership of the asset are calculated
for each year of the intangible asset’s economic life and then discounted to acquisition date present
values using an asset-specific discount rate
3. a TAB element is added to the post-tax present value of the royalty savings, if appropriate.
1 This is not a real-life example of a royalty database. Note this assumption is used for simplicity but is not very likely to occur in practice.
Identifying and valuing intangibles under IFRS 3 2013: Section B 31
Example B.14 – Valuation for a trademark
Royalty rate:
1.0%
Royalty base:
Entity revenues
Discount rate:
Income tax rate:
10.5%
30%
Economic life:
Tax amortisation period:
5 years
15 years
Date of valuation
1 January 2013
NB: Rounding applies
Period
All values are CU millions
Royalty base: Revenues
Pre-tax royalty income
Income taxes
Post-tax royalty income
2013
2014
2015
2016
2017
500.0
550.0
600.0
624.0
675.0
1.0%
5.0
5.5
6.0
6.2
30.0%
(1.5)
(1.7)
(1.8)
(1.9)
3.5
3.9
4.2
4.4
6.8
(2.0)
4.7
Discount factor
10.5% 0.905 0.819 0.741 0.671 0.607
Present values
Total present values
TABs (5 iterations)
Trademark fair value
3.17
3.15
3.11
2.93
2.87
15.23
2.64
17.87
The residual value is calculated by using the final forecast-year net after-tax royalty cash flows and capitalised using an
asset-specific discount factor. The sum of the discounted royalty cash flows over the projection period yields a value for
the intangible asset before tax amortisation benefits.
The TAB element reflects the tax benefit that an asset acquirer would hypothetically generate from amortising the
purchase price of the asset over 15 years. Five iterations have been implemented in the calculation to match
amortisation expenditure with total fair value inclusive of tax amortisation benefits.
4.3 Comparative income differential method (CIDM)
The comparative income differential model (CIDM) is commonly used where the relative income
stream of the intangible asset can be estimated. This method generally estimates the income differential an
asset will generate relative to its absence. In other words, the difference between the value of the business
with and without the intangible asset is used to estimate its acquisition date fair value. Non-compete
agreements and other marketing-related assets are common examples of intangible assets that are valued
with the CIDM.
Estimating the income differential
The CIDM generally requires a thorough analysis of the way in which the asset is expected to generate future
economic benefits, and the conditions necessary for this. The income differential generated (or protected) by
the asset may represent:
• additional sources or higher volumes of income
• cost savings, eg as a result of lower expenditures for marketing, human resources or similar functions
The CIDM is also
sometimes referred
to as the incremental
income method;
premium profit method;
or ‘with and without’
method.
of the entity
• a combination of both.
The process and level of detail required to estimate the income differential depends on the nature of the
intangible asset and the ways in which it contributes to the business. For less complex intangible assets, it
may be easy to identify a discrete stream of the differential income over the economic life of the asset. For
example, where the intangible asset generates cost savings, and these cost savings can be estimated with
reasonable reliability, the CIDM would focus on identifying and measuring the value of the cost savings.
Other intangible assets may generate economic benefits through a variety of different additional sources
of income and cost savings. A non-compete agreement with a former key employee of the acquired business
may for example protect the combined entity from losing sales with existing customers and allow lower
marketing expenditures otherwise necessary to maintain the entity’s existing customer base. To estimate the
differential income generated by more complex intangible assets, PFI may be required for the business as a
whole with and without the economic benefits of the intangible asset.
32 Identifying and valuing intangibles under IFRS 3 2013: Section B
Calculation methodology
The actual calculation methodology varies depending on the circumstances in each case. Further
important refinements may require for instance a probability weighting of different future outcomes
in the PFI or tracking the interdependencies of individual intangible assets. Common steps may be
summarised as follows:
1. the income stream attributable to the intangible asset is estimated. A common approach is to estimate
net income for the business as a whole with and without the intangible asset, which gives an estimate of
the income differential attributable to the asset. In less complex situations, it may also be appropriate to
estimate a discrete stream of income that the asset will generate during its economic life.
2. the present value of future differential income is determined. Asset-specific discount rates should
generally be used. Where the CIDM compares the value of the business as a whole with and without the
intangible asset, an entity-WACC is usually considered appropriate to discount income streams by the
entity as a whole.
3. TABs are added to the post-tax present value of the income differential expected to be generated by the
intangible asset, if appropriate.
Example B.15 – CIDM for a non-compete agreement
A non-compete agreement has been acquired in a business acquisition. The non-compete agreement is considered to be
a contractual identifiable intangible asset.
Under the terms of the contract, the head of sales of the acquired business is prohibited from taking up a similar
position at a competitor for a time period of 10 years. It is estimated that in the absence of the non-compete agreement,
the former employee would find a similar position and pose a threat to the acquired business without any time lag and
with full instant effect2. This would result in an erosion of sales with existing customers as well as additional marketing
costs to maintain the current customer base. However, as the former employee is 60 years of age, it is also estimated
that the non-compete agreement has economic substance only for the next 3-5 years. It is also estimated that the
potential ‘threat’ to sales of the acquired business will rapidly diminish after three years. The income differential expected
for the next 3-5 years is estimated as follows:
Year
Effect of competition on gross margin
Additional marketing expenditures
1
2
3
-20%
-23%
-25%
+10%
+18%
+10%
4
-10%
+5%
5
-5%
–
The ‘Effect of competition on gross margin’ reflects the theoretical erosion in the level of sales with existing customers in
the absence of the non-compete agreement. It is expected that competitive action of the former employee would have
an immediate impact on the level of sales. The impact is expected to increase until year 3 and decline thereafter as the
employee is expected to slowly withdraw from active business.
‘Additional marketing expenditures’ reflect the additional cost expected to protect the remaining customer base from
competitive action of the former employee.
2 Note this assumption is used for simplicity but is not very likely to occur in practice.
Identifying and valuing intangibles under IFRS 3 2013: Section B 33
Example B.16 – CIDM for a non-compete agreement (continued)
The CIDM is chosen as the appropriate method to measure the fair value of the non-compete agreement. The entity
WACC has been estimated at 9.9%, which reflects an average income tax rate of 30%. The enterprise value of the
income generated in the business under review for the next five years was determined at CU56,639. A valuation of the
entity without the non-compete agreement is determined at CU39,819:
Year
Gross Margin
1
2
3
4
5
30,000 31,500 33,075 34,729 36,465
– Effect of competition on gross margin
(6,000)
(7,245)
(8,269)
(3,473)
(1,823)
Gross margin without non-compete agreement
24,000 24,255 24,806 31,256 34,642
Marketing cost
– additional marketing expenditures
(7,600)
(7,980)
(8,379)
(8,798)
(9,238)
(760)
(1,436)
(838)
(440)
–
Marketing cost without non-compete agreement
(8,360) (9,416) (9,217) (9,238) (9,238)
Other cost
Pre-tax income
Income taxes
(3,100)
(3,178)
(3,257)
(3,338)
(3,422)
12,540 11,661 12,332 18,680 21,982
(3,762)
(3,498)
(3,700)
(5,604)
(6,595)
Net income without non-compete agreement
8,778 8,163 8,632 13,076 15,387
Discount rate
0.910 0.828 0.753 0.686 0.624
Present value of net income
7,988 6,759 6,500 8,970 9,602
Total present value without non-compete agreement
39,819
The indicative post-tax discounted income differential attributable to the non-compete agreement may be estimated at
CU56,639 – CU39,819 = CU16,820. TABs assuming a straight-line tax deduction over 15 years imposed on this value
after six iterations may be valued at CU3,038, thus resulting in an estimate of fair value for the non-compete agreement
of CU16,820 + CU3,038 = CU19,858.
4.4 Multi-period earnings excess method (MEEM)
The MEEM is commonly used when a reliable direct measurement of future economic benefits generated by
an intangible asset is not possible. The method takes a ‘residual approach’ to estimating the income that an
intangible is expected to generate. It generally starts with the total expected income streams for a business
or group of assets as a whole and deducts charges for all the other assets used to generate income with the
intangible asset under review during its economic life. Residual income streams are then discounted using
asset-specific rates. The need for a TAB must also be considered.
The MEEM is applied to a wide variety of intangible assets, especially those that are close to the
‘core’ of the business model (sometimes referred to as ‘primary’ or ‘leading’ assets). In practice, customer
relationship assets, technology, and IPR&D are among the intangible assets frequently valued using
the MEEM.
Contributory asset charges (CACs)
The main feature of the MEEM is the specific consideration it gives to contributory asset charges (CACs) in
identifying the residual income stream that the intangible asset is expected to generate. The fundamental
premise of the MEEM is that the value of an intangible asset is equal to the present value of the net income
that is attributable to it. The income streams attributable to the intangible asset are those in excess of the fair
returns on all assets that contribute to the income generating process (‘contributory assets’).
CACs generally reflect an estimate of the amount a typical market participant would have to pay to use
these contributory assets to generate income with the intangible asset. CACs comprise two elements
•
•
the return of investment
the return on investment.
34 Identifying and valuing intangibles under IFRS 3 2013: Section B
The return of investment reflects the economic depreciation of the contributory asset that a third party
would expect as reimbursement to recover its initial investment in the asset. The return on the investment
is the charge a third party would expect as a profit in addition to the return of investment. If an entity for
example leases a car, the related arm’s length lease payment usually reflects the depreciation of the car (ie
the return of investment) as well as a profit margin (ie the return on investment).
In practice, the PFI used for fair value estimation may not include all the costs a typical market participant
would incur to use the various assets that are required to generate the income. Judgment is therefore
required to complement the PFI with CACs. This requires the identification of the relevant contributory assets
and an assessment of whether the return of and on investments in all contributory assets is appropriately
reflected in the PFI.
CAC are also
sometimes referred to
as capital charges or
economic rents. They
generally reflect an
estimate of the amount
a third party would
charge for the use of a
contributory asset, ie an
asset that is necessary
to generate income with
the intangible asset.
Identification of contributory assets
A full review of the business model is required to identify all assets that contribute to the income
generation process of the intangible asset under review. Contributory assets generally consist of some of
the following elements3:
Type
Examples
Explanation
Capital investments
Assembled workforce
land, plants and other buildings
•
• machinery and tools
IT Infrastructure
•
technology-related, marketing-related
•
and other intangible assets (including
intangible assets not (yet) recognised
in the balance sheet)
• natural resources
• manufacturing and production staff
• management
•
sales personnel, research and
development staff
• administrative staff
Capital investments are necessary for the actual
production process of the intangible asset. Property, plant
and equipment assets are for example necessary for
physical production to take place. Intangible assets may
eg provide know-how for production or enhance marketing
of the output.
Businesses generally require a workforce to generate
income from any asset.
Working capital
•
•
inventories
financing functionality, ie trade receivables
and payables, cash and cash equivalents
Working capital facilitates the income generation process.
Without the relevant current assets, income generation
would not be possible.
• other current assets
The assembled workforce is technically not an identifiable intangible asset and is therefore subsumed into
goodwill (see Section A.3). Nevertheless, for the purpose of acquisition date fair value measurement it is
seen as a resource because a typical market participant typically needs a workforce to generate income with
the intangible asset under review. In practice, CACs for the assembled workforce are therefore commonly
taken into account under the MEEM. The assembled workforce is often the only element of goodwill that is
especially considered as a contributory asset.
Some contributory assets such as property, plant and equipment and working capital are readily
identifiable and have been recognised in the acquiree’ s pre-combination financial statements. However,
some contributory assets may not have been recognised as an asset by the acquiree or by the combined
entity and further analysis is therefore necessary. This applies particularly to intangible assets other than
the intangible asset in question. If the acquired business relies on third-party assets (such as in leasing or
outsourcing arrangements), these assets might also need to be taken into account.
Contributory assets
comprise all resources
required in the income
generation process of
the intangible asset,
regardless of whether
these resources are
considered identifiable
assets of the
acquired business.
3 This list is not meant to be exhaustive. Identification of the contributory assets actually required for a specific income generation process will depend on the
facts and circumstances of the relevant intangible asset.
Identifying and valuing intangibles under IFRS 3 2013: Section B 35
Example B.17 – Identification of contributory assets
A tile manufacturer business is acquired in a business combination. The acquired business is widely known for
the high-quality, weather-proof tiles it produces in its own manufacturing facilities. It has been selling its output to
contractual customers for a number of years. The acquiree also sells other manufacturers’ tiles to its customers on
a commission basis.
The acquirer applies the principles of IFRS 3 and identifies the following assets and their fair values:
Fair value (CU) Customer relationship
contributory asset
Identifiable asset
Tile manufacturing plant
Land (held for investment purposes)
Warehouse
Financial investments
Weather-proofing technology
Tile customer relationship asset
Inventories and other working capital
Non-identifiable asset
12,000
7,500
2,500
5,000
10,000
Yet to determine
6,000
Assembled workforce (element of goodwill)
12,000
Yes
No
Yes
No
Yes
–
Yes
Yes
The column on the right reflects the result of a further assessment into whether each of the assets contributes to the
income generation process from existing customers from its tile manufacturing business. In a business model review, it
is determined that the land and the financial investments are not used in the production process and are therefore not
necessary to utilise the relationship with customers in the manufacturing business. The weather-proofing technology is
however considered to be a crucial factor in continuing to do business with these customers. It is therefore considered
a contributory asset, despite the fact that it was not recognised as an intangible asset in the financial statements of the
acquiree prior to the combination.
In addition, it is concluded that the skills of the assembled workforce are important in terms of continuing to do
business with the customer. Despite failing the definition of an identifiable intangible asset, it is still considered a
contributory asset of the customer relationship asset.
The actual usage of contributory assets also needs to be analysed. Some contributory assets will contribute
to the income generation of more than one intangible asset. For these shared contributory assets, any related
CAC needs to be allocated amongst relevant intangible assets by reference to the actual level of usage of the
contributory asset.
36 Identifying and valuing intangibles under IFRS 3 2013: Section B
Example B.18 – Shared contributory assets
As indicated in the previous example, the acquired tile manufacturing business also provides other manufacturers’ tiles to
its customers on a commission basis. The customer relationship asset, however, is limited to customers to which the
entity sells its own tiles. Against this background, a further review of the business model reveals that roughly half of the
inventories and other working capital are used in the commission business. It is also estimated that 40% of the
warehouse capacity and 25% of the employees are necessary to provide third-party tiles to customers.
Taking into account the assessment from the first part of this example, contributory assets may be summarised
as follows:
Contributory assets
Estimated usage
Relative fair value of
contributory asset (CU)
Tile manufacturing plant
Warehouse
Weather-proofing technology
Inventories and other working capital
Non-identifiable asset
Assembled workforce (element of goodwill)
100%
60%
100%
50%
75%
12,000
1,500
10,000
3,000
9,000
Return of contributory assets
A careful analysis of the available PFI is necessary to determine whether the return of contributory assets
needs to be specifically imputed into the MEEM. PFI often readily reflects the return of all assets in operating
costs. For example, the acquiree’s available budgets and projections may reflect returns of
assets as follows:
•
the return of investments in property, plant and equipment may be represented in forecast
depreciation expenses
• marketing budgets may include the cost of maintaining the existing brand or customer base
•
forecasted expenditures of the human resource department may represent the cost of maintaining
the assembled workforce
• R&D expenditure may already represent the return of investments in technology-related
intangible assets (regardless of whether these were recognised in the acquiree’s balance sheet prior
to the combination).
Adjustments are necessary to the extent that the return of any of the contributory assets is not appropriately
reflected in forecast financial information. This is often the case where the forecasts omit costs to maintain
or replace contributory assets or do not appropriately reflect their ‘usage’ by the relevant intangible asset, as
previously discussed. Marketing budgets may for example also reflect the cost to acquire new customers. A
modification of the PFI may therefore be necessary to exclude customer acquisition cost when an intangible
asset is measured that represents the existing customer base.
Identifying and valuing intangibles under IFRS 3 2013: Section B 37
Contributory assets not
owned by the entity
Under the MEEM, CAC
are usually estimated
for contributory assets
owned by the entity.
Where the entity does
not own the contributory
asset, the return of and
on the asset is usually
reflected in forecasted
lease payments or
similar expenditures
expected by the entity
for the use of a third-
party resource.
Return on contributory assets
PFI typically omits a fair return on contributory assets. While investments in new assets and resources (ie
the return of contributory assets) are often considered in preparing the PFI (see above), the opportunity
cost of using the acquired entity’s own contributory assets is usually not reflected in the PFI. In other
words, the ‘profit’ a third-party supplier would theoretically charge is usually not forecasted when the
entity owns a contributory asset. CAC used to identify residual income for the intangible asset under the
MEEM will typically therefore specifically address the fair return on contributory assets that are actually
owned by the acquired entity.
There are no set rules as to how the fair return on a contributory asset should be determined. As best
practices are still emerging, different methods may be acceptable. Any rate of return on an investment would
however typically reflect the risk characteristics of the specific asset as well as the overall context of the
industry it is used in. In practice, the rate chosen is therefore often consistent with the asset-specific discount
rate of the contributory asset which is derived from the industry-specific WACC (see Section B.4.1). This rate
is then multiplied by the fair value of the contributory asset to work out the actual return a third party would
require as a return on a specific investment in the contributory asset. For a brand/trademark intangible asset,
the contributory asset would be calculated at the royalty rate that is used in the valuation of that asset.
Example B.19 – Return on contributory assets
Continuing the previous example, asset-specific discount rates have been determined for each contributory asset. CAC
that reflect the return on contributory assets at the date of acquisition may be calculated as follows:
Contributory assets
Pre-tax partial
Asset-specific
Pre-tax return on
fair value (CU)
discount rate contributory asset (CU)
Tile manufacturing plant
Warehouse
Weather-proofing technology
Inventories and other working capital
Non-identifiable asset
12,000
1,500
10,000
3,000
5.00%
5.00%
18.00%
5.00%
600
75
1,800
150
Assembled workforce (element of goodwill)
9,000
16.67%
1,500
The approach illustrated in the previous example allows an estimate of CAC that is appropriate at the
acquisition date. It benefits from the common practice of checking the asset-specific discount rate for
plausibility in a ‘return test’ (see Section B.4.1). The level of usage of contributory assets may however be
subject to change during the economic life of the intangible asset. Hence, different levels of CAC will apply to
different forecasted periods and a further analysis may be necessary to estimate whether the CAC may react
to for example sales, technical or general economic developments or other conditions. One method used in
practice estimates CACs as a percentage of expected sales volume.
38 Identifying and valuing intangibles under IFRS 3 2013: Section B
Calculation methodology
The calculation methodology used in practice will generally depend on the available data and the
economic characteristics of the intangible asset. Application of the MEEM should also reflect the conceptual
characteristics of fair value (see Section B.1.5) as well as the key inputs to income approach methods (see
Section B.4.1). In summary however, the MEEM requires the following steps in arriving at a fair value-estimate
for the intangible asset:
1. the PFI attributable to the intangible asset and the related contributory assets is obtained. The estimates
should incorporate all factors that a typical market participant would take into account in pricing the
asset. Buyer-specific synergies are excluded from the PFI
2. contributory assets are identified. If CACs are estimated on the basis of their fair values, then these have to
be determined first
3. CAC adjustments are incorporated into the estimates to the extent that these are not already included.
The income stream is usually reduced by income taxes that are expected to be paid as a result of the
income generation process
4. the residual income calculated for each year of the intangible asset’s economic life is discounted to its
acquisition date present value. Asset-specific discount rates are usually used in calculating these present
values (see Section B.4.1)
5. a TAB element is added where appropriate (see Section B.4.1).
Application of the MEEM in the context of other income approach methods
Generally, if intangible assets are valued using the MEEM, the fair value of all contributory assets have to be
estimated first. Application of the MEEM may involve further iterations due to interdependencies between
the different income approach methods:
• asset-specific discount rates are typically estimated in the context of all assets of the acquired
•
business, eg in a ‘return test’ (see Section B.4.1). If one fair value is changed, a re-consideration of other
discount rates may be necessary. Changes in discount rates in turn may change fair values of other
identifiable assets
if CAC are estimated on the fair value and asset-specific discount rates for the relevant contributory assets
and their fair value or discount rates are changed, then this will affect CAC used in the MEEM. This may
represent mathematical difficulties if the fair value of more than one intangible asset is estimated on the
basis of the MEEM.
Identifying and valuing intangibles under IFRS 3 2013: Section B 39
Example B.20 – MEEM for a customer relationship intangible asset
Financial forecasts have been reviewed in order to identify the appropriate PFI to estimate the fair value of the customer
relationship intangible asset in the tile manufacturing business. Expected revenues from existing customers are expected
to erode within 6 years and a customer attribution rate has been estimated. All relevant expenditures are expected to
correlate 100% with the development in revenues. An analysis of the PFI also shows that the return of all contributory
assets are already included in the projected cost of sales and other expenses.
From the perspective of a typical market participant, an income tax rate of 30% is estimated as appropriate. It is also
assumed that customer relationship intangible assets are typically tax amortisable over a period of 15 years. The asset-
specific discount rate is estimated at 15%.
PFI
Revenue
2007
2008
2009
2010
2011
2012
40,000
36,000
25,920
11,197
2,902
Customer attrition
100%
90%
72%
43%
26%
(26,800)
(24,120)
(17,366)
(7,501)
(1,945)
(6,000)
(5,400)
(3,888)
(1,680)
7,200
6,480
4,666
2,016
Cost of sales
Other expenses
Income before CAC
CAC
– for tile manufacturing plant
– for warehouse
– for assembled workforce
Income before taxes
Income taxes
– for weather-proofing technology
(1,800)
(1,620)
(1,167)
– for inventories and other working capital
(150)
(135)
(600)
(75)
(510)
(67)
(389)
(49)
(97)
(972)
(1,500)
(1,350)
3,075
2,798
1,992
(923)
(839)
(598)
(168)
(21)
(504)
(42)
(418)
863
(259)
376
13%
(252)
(56)
68
(6)
(1)
(17)
(1)
(14)
29
(9)
(435)
522
(44)
(4)
(131)
(11)
(109)
223
(67)
Net income attributable to tile
2,152
1,959
1,394
604
156
20
customer relationships
Present value factor
Present values
Total present values
TABs (5 Iterations)
Fair value
0.870
0.756
0.657
0.572
0.497
0.432
1,872
1,481
916
345
78
9
4,701
623
5,324
40 Identifying and valuing intangibles under IFRS 3 2013: Section B
C. Common intangible assets in
business combinations
The main considerations in accounting for intangible assets in business combinations are:
• which identifiable intangible assets have been acquired?
• what characteristics affect their fair value and how should they be measured?
These questions generally need to be answered on the basis of the facts and circumstances of the
transaction and the intangible asset’s unique characteristics. This Section considers some of the most
common types of intangible assets acquired and recognised in practice, and the techniques used to
value them.
1. Marketing-related intangible assets
The most common types of marketing-related intangible asset include trademarks, service marks and related
items, internet domain names and websites as well as non-compete agreements.
1.1 Trademarks, service marks and related items
Many businesses own one or more registered trademarks or service marks (referred to as ‘trademarks’ for
simplicity). These trademarks identify the source of a product or service and help differentiate that product or
service from competing offerings. The legal protection of a registered trademark or service mark extends to
related wording, the (trade) name, a symbol (such as a logo), even a device or a combination of these means
of identification.
A trademark generates future economic benefits for its owner in two ways: it may increase sales volumes
and it may enable its owner to charge premium prices in comparison to similar unbranded products and
services.
Control over these potential future benefits is customarily achieved by legal registration of the trademark.
The registration also satisfies the contractual-legal criterion required to identify an intangible asset separately
from goodwill.
The relief-from-royalty method is often used to estimate the fair value of a trademark. The royalty base of
a trademark is typically the projected volume of sales attributed to it. Royalty rates can be estimated on the
basis of information gathered from royalty databases and by reference to recent transactions of the acquiree
or the acquirer. Section B.4.2 provides further guidance on estimating royalty rates.
Trademarks that
represent a ‘brand’ are
sometimes measured
in conjunction with
complementary assets,
such as a trade name,
logo, formula or
technology (see
Section A.2.3).
Identifying and valuing intangibles under IFRS 3 2013: Section C 41
Characteristics that affect the fair value of a trademark
• how long the trademark has been actively used in marketing
•
type of market (eg consumer markets, B2B, etc)
• how widely the acquired entity uses the trademark (specific service lines, all products and services or in specific
geographical areas)
• whether the entity uses a number of interchangeable trademarks to market similar products to different customers
•
legislation covered by similar trademarks and the related names, symbols etc
• whether the trademark is also used to represent the acquired entity as a whole
•
the extent that the entity’s marketing is dependent on the use of trademarks or if other factors, such as core
technology, are advertised to customers and make the trademark less relevant.
The MEEM and CIDM are also used. Use of these methods should be considered especially when trademarks
and related marketing intangible assets are very significant for the acquired business. The CIDM and MEEM
both involve a more detailed examination of the asset in question and might therefore provide a more
reliable estimate of fair value.
1.2 Internet domain names and websites
An internet domain name represents the numeric IP address through which an entity’s website is accessed
on the internet. The significance of a website does of course vary extensively from one business to another:
for some businesses the internet is an important source of revenue; for others the website is primarily one of a
range of media used to communicate basic information about the business such as locations, goods
or services and contact information. In either case, the internet domain name and the appropriate
website may represent potential future economic benefits as a result of additional income streams and
increased business.
Control over the domain name is usually obtained by registration, which restricts third-party use. Domain
names therefore normally meet the contractual-legal criterion for identifiability. The website is normally
copyrighted and its operation may also be dependent on third-party software (see below). In practice, the
value a typical market participant would ascribe to a domain name will vary with its use (and potential use).
If the entity’s website is a significant point of sales the domain name is more likely to be significant. The
name associated with a website used only to provide product information and contact details is less likely to
be of significant value. Some domain names also have value as a result of the appeal of the name itself (eg
www.books.com). In many cases, the economic benefits of a domain name may then also be appropriately
reflected in another marketing-related intangible asset, such as a ‘brand’ or trademark (see above).
The choice of valuation methodology will generally depend on the significance of the domain name
for the business and the revenue generated. An income approach method such as the relief-from-royalty
method should be considered, as domain names are frequently the subject of licensing arrangements.
The CIDM or MEEM may be preferable if the business relies heavily on the internet to generate revenue. If
however a similar internet presence with a comparable impact on the business model is easily reproduced, a
cost approach such as the reproduction cost method may also be acceptable.
1.3 Non-compete agreements
Non-compete agreements are frequently entered into in the course of a business combination. These
agreements offer a degree of protection to the new owner of a business from competition by the vendor,
the vendor’s owners and its key personnel. If the vendor is an incorporated entity, a non-compete agreement
may also extend to the vendor entity as a whole.
Non-compete agreements may reduce the risk of the acquired business losing customers to the vendor.
They might also prevent the vendor from seeking to recruit key employees of the acquired business, thereby
reducing future recruitment and training costs and improving the retention of know-how within the business.
Non-compete agreements may therefore represent future economic benefits in the form of higher sales
and lower costs. Control over the future economic benefits is created by the non-compete agreement itself
(which meets the contractual-legal criterion for identifiability).
42 Identifying and valuing intangibles under IFRS 3 2013: Section C
Non-compete agreements
Non-compete agreements may sometimes be legally enforceable but of little economic substance – the counterparty
may for example be restricted from competing by other means (eg copyrights or otherwise protected technology) or the
agreement may affect only specific industries or geographic locations that are insignificant for the acquired business.
A non-compete agreement may also be of little substance when the counterparty actually remains with the combined
entity and is well compensated or when the counterparty is close to his or her retirement age. In both cases, the
economic impact of the otherwise possible competition may be limited.
Non-compete agreements are commonly valued using the CIDM to take account of the incremental income
they generate or protect (see Section B.4.3). Cost measures, on the other hand, are often not available in
practice as non-compete agreements are frequently part of the purchase agreement that effected the
business combination.
The value of a non-compete agreement is dependent on the likely impact of competition that would be
faced in the absence of the agreement. Some of the factors that should be considered in estimating the fair
value of the agreement include:
•
•
• areas where business might be lost or additional costs would be incurred in the absence of the non-
the period of the non-compete agreement
its enforceability
•
compete agreement
the likelihood of counterparty competition, especially where the acquired business depends on otherwise
legally protected technology
• characteristics of the counterparty that affect the economic substance of the agreement. This may include
the importance of the individual for the acquired business prior to the combination, his/her
age as well as the actual economic and physical capability of the individual to compete. The
capability to compete with the acquired business should also be considered if the counterparty is an
incorporated business.
Some business sale and purchase agreements specify how much of the total compensation relates to the
non-compete agreement. These specified amounts are not necessarily indicative of the fair value of an
agreement: the allocation of the total consideration might be influenced by several other factors such as
tax planning issues.
2. Customer-related intangible assets
The three customer-related identifiable intangible assets that are most commonly found in a business
combination are customer lists (or similar databases), open orders and production backlogs (sometimes
referred to as customer contracts) and customer relationships.
Which asset do customer related benefits belong to?
In estimating fair values of customer-related intangible assets, special consideration should be given to the question of
which future economic benefits are actually represented by each of the intangible assets under review. The value of one
customer-related intangible asset may sometimes be reflected in another one – for example, fair value measurement of
current customer contracts and their possible renewals may sometimes incorporate the fair value of the underlying
customer relationship. In other cases where customer relationships by themselves do not meet the definition of
identifiable intangible assets, the related value components may also be reflected in a marketing-related intangible asset.
A careful analysis is therefore essential to avoid double counting the same economic benefits.
2.1 Customer lists or similar databases
Customer lists or similar databases contain intelligence about current and sometimes potential customers
of the acquired business. Examples vary from simple address books with the relevant contact information
to very sophisticated databases that capture information on customer demographics, preferences,
relationship history and past buying patterns (for example). Customer loyalty schemes are often designed
to facilitate capture of this type of information and therefore indicate the existence of a related customer
list or database.
Identifying and valuing intangibles under IFRS 3 2013: Section C 43
Information about customers is generally useful in improving the effectiveness of sales and marketing
efforts. Other economic benefits may result from rental or sale of the list or database. Control is usually
obtained by internal controls over access to and use of the list or database. The value of a database is not
necessarily reduced or negated simply because the acquirer already has access to comparable information –
as always, the perspective of a typical market participant is assumed.
The identifiability of this customer-related intangible asset usually depends on whether it would be
possible (practically and economically) to separate the customer list or database from the acquired business
without disposing of the entire business. For example, if the intangible asset could be transferred to a third
party in a licensing or sales agreement, this would indicate that it is separable. Barriers to separation of a
customer list and related information (and hence identifiability) should however be considered. Such barriers
might for example result from binding confidentiality agreements or laws that restrict the ability to transfer to
a third party.
The replacement cost or reproduction cost method is often used to estimate the fair value of customer
lists and similar databases, especially if a duplicate is easily obtainable. Customer lists may for example be
available for purchase, in which case a fair value estimate could be based on current replacement cost. In
other circumstances, it may be possible to compile a customer list or similar database internally. An estimate
of the cost to reproduce would typically reflect some of the following conditions:
•
• estimated time to reproduce and cost of employment if the intangible asset was reproduced
• related overhead costs, eg relating to management, quality assurance, IT support
• external expenditure, eg involvement of external market research services.
level of detail and accuracy
An income approach method may be more appropriate to estimating fair values of customer list or
similar databases that are not easily reproduced or replaced. In fact, if the customer list or similar database
represents a key advantage of the acquired business due to its unique characteristics, then an income
approach method such as the MEEM usually takes better account of the expected economic benefits. A
fair value estimate would consider components of value that are similar in nature to customer relationship
assets, as discussed further below.
2.2 Customer contracts: open orders and production backlogs
Customer contracts may represent fairly certain future economic benefits as they usually identify the
counterparty, the products and services to be supplied and the expected revenue. The entity can therefore
estimate the future profit it will earn on fulfilling the contracts, open orders and production backlog in
the post-acquisition period.
Control over the customer contract intangible asset usually resides in the contract itself. An open
contract also satisfies the contractual-legal criterion for identifiability (even if the contract under review
is cancellable). In our view, contacts that are pending but not yet effective at the acquisition date, do not
normally qualify to be recognised as identifiable assets.
Customer contracts are commonly valued using income approach methods. Depending on whether
the customer contracts are considered in connection with the underlying customer relationship or
individually, both the CIDM and the MEEM may provide a reliable fair value estimate:
• when customer contacts are valued individually, the CIDM allows an estimate of the additional
income the contracts under review will generate. A fair value estimate would take into account
additional revenues and related costs to complete the contract, together with the lower marketing
costs. This scenario would then be compared to PFI prepared under the alternative scenario that open
contracts, orders and production backlog did not exist at the acquisition date
• where it is reasonable to expect contract renewals that share the same risk characteristics as the
underlying customer relationships, then it may be more appropriate to combine both types of
customer-related intangible assets. The MEEM is commonly used to address the broader issue of
customer contracts and the related customer relationship. However, substantial contracts or order
backlogs are often treated as separate intangible assets in practice, as their economic characteristics
are often different from the related relationship with the customer. Expected cash flows from open
orders are of course less ‘risky’ than cash flows from potential future orders that may result from
customer relationships.
44 Identifying and valuing intangibles under IFRS 3 2013: Section C
The following aspects
affect the economic
substance of customer
contracts and should
be reflected in their fair
value measurement:
• average profit margin
under consideration of
all inputs required in
the income generation
process
• economic life, usually
represented by the
remaining duration of
the contract
• the possibility of a
renewal, extension
or amendment of
the contract or its
cancellation.
2.3 Customer relationships
It is important to distinguish the value attributed to current order or production backlogs from a customer
relationship. A customer relationship often represents future economic benefits in the form of future business
with a customer beyond the amount secured by any current contractual arrangements. The economic
substance of a customer relationship also differs from that of a customer list or similar database. The latter
derive value from intelligence about current and potential customers (see above) and therefore may enhance
the benefits that the entity can obtain from an existing relationship with a customer.
Do customer relationships meet the definition of an asset?
The question often arises as to whether customer relationships meet the criteria to be recognised as an asset. Outside
of a business combination, IAS 38.16 suggests that the entity usually has insufficient control over the future economic
benefits for these relationships to meet the definition of an intangible asset. The implementation guidance to IFRS 3, on
the other hand, takes the view that a customer relationship asset exists if the entity has information about the customer
and regular contact, and the customer is able to contact the entity. These relationships are recognised as assets if the
entity establishes contracts with its customers or if they are separable. Although IFRS 3 does not directly address the
control issue, its requirements are specific – the discussion in IAS 38 cannot therefore be used to avoid separate
recognition of customer relationship assets that meet the conditions of IFRS 3. Current developments in the world of
IFRS show that regulators and other interested parties in practice interpret customer relationships as assets if they
are identifiable.
IFRS 3 explains that “…if an entity establishes relationships with its customers through contracts, those
customer relationships arise from contractual rights…” (IFRS 3.IE26). The contract satisfies the contractual-
legal criterion, and the customer relationship intangible asset is therefore considered identifiable. This
requirement in the original version of IFRS 3 led to diversity in practice, in part due to differing views as to
what is meant by a customer contract. The 2008 version of IFRS 3 clarifies this – customer relationships exist
if the entity has information about and regular contact with the customer and the customer has the ability
to make direct contact with the entity (IFRS 3.IE28). By contrast, anonymous sales transactions (for example
a retailer’s sales to walk-in cash customers) do not create a contractual customer relationship asset for the
purposes of IFRS 3 even if the sales transaction establishes a contract in legal terms.
In practice, contractual customer relationship assets are very common. This is because most businesses
establish relationships with customers through contracts. For this purpose, contracts might include specific
purchase orders as well as longer term supply arrangements. Further, IFRS 3 does not require the customer
contract to be current or active at the date of acquisition. If a past customer contract is likely to result
in future business beyond current or recent contractual arrangements, then this may indicate a valuable
contractual customer relationship asset (see IFRS 3.IE26-30).
IFRS 3 also indicates the possibility of customer relationships that are non-contractual (IFRS 3.IE31). These
may for example arise if the entity does not enter into contracts with its customers or does business via sales
or service representatives (which in turn maintain the customer relationship). Alternatively, the customer
relationship may not be considered contractual in the terms of the standards, eg when the entity does not
know the identity of the individual customer or is not regularly in contact with the customer (IFRS 3.IE28).
In these circumstances, the intangible asset is only considered identifiable if exchange transactions for
the same or a similar asset demonstrate that it could be separated either individually or in combination
with another asset outside a business combination (IFRS 3.IE31 or IAS 38.16). As this may prove difficult to
demonstrate, non-contractual customer relationship assets may be recognised less frequently in practice.
Future economic benefits from non-contractual customer relationships are therefore often effectively
reflected in a trademark or other marketing-related identifiable asset or simply subsumed in goodwill.
Identifying and valuing intangibles under IFRS 3 2013: Section C 45
Combinations of customer relationship intangible assets with customer databases or
customer contracts
In practice, customer contracts (open orders and production backlog) and the related customer relationship asset are
often combined with other assets due to their economic similarities (see also Section A.2.3). Especially where long-term
contracts are in place that are frequently renewed without substantial further efforts by the entity, both types of
intangible assets share the same economic characteristics and the value provide by the likelihood of contact renewals
may be readily reflected in the customer contract intangible asset (or vice versa). On the other hand, if continued
marketing and related expenditures are necessary to retain existing customer relationships and competition is more
likely to affect the customer base, then a separate treatment of the two types of customer-related intangible assets may
be more appropriate.
Customer lists and similar databases are also commonly combined in practice with the related customer
relationship asset. If continued business with the customer depends on detailed knowledge about customers’ behaviour,
then the customer relationship intangible asset may be readily reflected in the fair value measurement of the database
asset (or vice versa). However, if the customer list is easy to reproduce, but substantial marketing efforts are necessary
to win a new customer, then this may indicate that the two types of assets should be treated separately.
The economic substance of an identifiable customer relationship asset is assessed from the
assumed perspective of a typical market participant. Accordingly, the fair value of a customer
relationship is not usually affected by whether the specific acquirer has a pre-combination relationship with
the same customers.
Customer loyalty
The economic life of customer relationship assets are usually determined by estimating the future loyalty of customers.
Some aspects to take into consideration include:
•
•
the ‘age’ of the customer relationship and past sales volume
the context of past business, eg record of continued business or whether the entity is considered a
‘preferred supplier’
• whether customer relationships are supported by customer contracts
•
the impact of competition on customer loyalty
• whether the customer relationship is focused on specific products or services or if additional business is possible
with existing customers (see also IFRS 3.IE30 (b))
•
importance of existing and future technology.
The MEEM is often the method of choice to estimate the fair value of customer relationship intangible
assets. In using the MEEM, a common application question concerns the appropriate level of aggregation
or disaggregation of the customer base. In other words, should the entire customer base be assessed as a
whole or is it more reasonable to focus on individual customers or smaller groups of customers. For example,
where the five most important customers account for a substantial part of the entity’s revenue, then it may
be appropriate to determine fair value for the ‘top 5 customer relationships’ separately from other customer
groups. Further segmentation of the customer base may focus on the different products and services
provided to customers, the geographic location of the customers or other sales volume.
The assessment of the customer base should also include the likelihood of whether products and services
may be provided that are different from the ones provided to the customer in the past. A typical market
participant would probably allocate value to possible additional business with existing customers. This
should be reflected in the PFI used in the MEEM.
Historical data is often used to estimate future ‘attrition’, ‘shrinkage’ or ‘churn’ rates, which represent the
probability that the customer relationship will eventually be discontinued. These rates affect the intangible
asset’s economic life and how PFI needs to be modified in the MEEM (see Section B.4.4 for a basic illustration).
Typically, to estimate the fair value of existing customer relationships, the PFI also needs to be modified to
eliminate any marketing costs that are associated with winning new customers.
46 Identifying and valuing intangibles under IFRS 3 2013: Section C
3. Technology-related intangible assets
Technology-related intangible assets are very fact specific. The assets to be identified and the choice of
measurement method depend extensively on the transaction and the industry of the acquired business.
Computer chip manufacturers are for example likely to be reliant on patents and high-technology production
processes. An internet retailer might rely on its website and self-developed software solutions.
Technology-related intangible assets do not have to be particularly ‘cutting edge’ to be of significant
value. A milk processing operation will for example rely on well-established dairy processing technologies
and similar know-how. The technology may nevertheless meet the definition of an identifiable intangible
asset and represent a significant resource from the typical market participant’s perspective.
3.1 Third-party software licenses
Virtually all businesses run third-party software (eg operating systems, office and business software).
Some of the underlying licenses might be recognised in the financial statements of the acquire (making
them easier to detect). Control over third-party software is usually maintained through licenses, which
also satisfy the contractual-legal criterion of identifiability. The main source of future economic benefits
presented by third-party software licenses is cost savings as the acquirer would have to purchase new
licenses or develop its own software solution.
The following factors may affect the economic substance of third-party software licenses and
should be taken into consideration when estimating their fair values:
•
the nature, original cost and age of the software license
• whether and to what extent the software is still used by the acquired entity at the date of acquisition
•
•
the number of users permitted under the license(s)
the duration of the license and other terms, including whether the software license may be sold to another party.
Third party software is often measured by references to its replacement cost. Aspects to take into account
include the current costs to obtain and install a new software license with similar functionalities. Differences
in functionalities which have been implemented in newer versions of the software should also be considered
– outdated third-party software is likely to be valued at a discount compared to a new product with similar
characteristics. A basic illustration of this approach can be found in Section B.3.3.
3.2 Technology (other than third-party software)
Technology may provide very significant and sometimes unique advantages to a business. Technology-based
intangible assets may include both developed technology as well as technologies under development (ie
in-process research and development (IPR&D)). It also comprises technology protected by patents as well as
legally unprotected technology. Examples to look out for include:
• computer software (other than third-party software, see above), eg for internal use or for licensing
• production processes
•
• recipes
• databases other than customer lists (see above) (eg a laboratory notebook).
formulae
Future economic benefits of technologies may be cost savings or additional income streams. Some
technologies are legally protected for a stated period of time due to legislation such as copyright laws or a
patent registration. Control and identifiability is then achieved through legal rights.
Identifying and valuing intangibles under IFRS 3 2013: Section C 47
The fair value of a technology intangible asset may reflect some or all of the following aspects:
• which current and future goods or services depend on the developed technology either directly or indirectly
• how the technology enables cost savings or additional income streams compared to a situation without
the technology
• whether the technology is fully developed or whether it is an in-process research and development project (IPR&D)
•
for IPR&D, the stage of progress and the potential risk involved in completing the project together with past
experience regarding the successful completion of similar IPR&D
• whether the technology can be considered core technology or whether it is specific to a limited number of goods
or services
• how the entity restricts third-party use of the technology (eg by patent applications or copyrights)
• how long the entity will benefit from the technology.
By contrast, some technologies are kept secret because legal protection is not possible or registration
exposes the technology to outside parties. It may be more difficult in these circumstances to determine
control and identifiability. Control over the technology may however be demonstrated if appropriate
measures are in place to ensure confidentiality. The intangible asset may in any case be identifiable as a result
of being separable from the acquired business.
Fair value measurement for entity-specific technology is very fact specific and usually depends on
the relative importance of the technology for the income generation process of the acquired entity. The
reproduction cost method for example may be appropriate to approximate the fair value of internally
developed software and similar technologies that do not directly contribute to the income generating
process of the acquired entity. Examples include business software solutions that are used in bookkeeping or
warehouse management and also IPR&D technology in its very early stages.
Income approach methods are usually more appropriate for estimating the fair values of more advanced
or fully developed technologies, especially where these contribute directly to the current or future income
generation process:
• where the technology could be licensed to a third party, a relief-from-royalty method should be
considered. This method is commonly used for patents, copyrighted technology or software that is
licensed to third parties provided that appropriate royalty rates can be estimated reliably
• when the technology provides its owner with distinguishable relative advantages such as additional
•
income streams or cost savings, then it may be appropriate for the CIDM to estimate acquisition date
fair value. The CIDM should for example be considered to estimate fair values of internal production
processes or databases that allow cost savings
the MEEM is also commonly used to estimate the fair value of technology-related intangible assets,
especially where these are very significant to the acquired business. It may for example be appropriate
for the MEEM to value patents, IPR&D as well as web-based businesses’ website and related software that
were developed internally by the acquiree.
In estimating the fair value of technology, IPR&D should always be measured separately from developed
technology. Measurement of IPR&D intangible assets generally requires additional inputs to reflect the risk
involved with their completion. In addition, specific accounting rules apply for subsequent expenditure on an
acquired in-process research and development project (IAS 38.42).
4. Other contract-related intangible assets
A number of other contract-based intangible assets may be detected in a business combination. Reacquired
rights and operating lease contracts are specifically addressed by IFRS 3. Supplier agreements or
licensing arrangements and other rights of use may also represent a material component of the value
of the acquired business.
It is the nature of contract-based intangible assets that they are generally straightforward to detect. They
are identifiable as they meet the contractual-legal criterion (by definition) and the underlying contract also
allows control over the future economic benefit created by the asset.
48 Identifying and valuing intangibles under IFRS 3 2013: Section C
4.1 Reacquired rights
Reacquired non-monetary rights are by definition identifiable intangible assets (see IFRS 3.29 and B35-36) and
require separate measurement and recognition. Examples include:
• software licenses (where the software was developed by the acquirer)
•
• patent licenses (where the acquirer is the patent-owner).
franchise agreements (where the acquirer is the franchisor)
Reacquired rights are one example of the few asset-types for which IFRS 3 departs from its normal fair value
measurement requirements. In summary, IFRS 3 specifies that measurement of a reacquired right is limited to
the remaining term of the underlying contract. In other words, the valuation does not take into account the
likelihood or possibility of renewal of the contract, even if a typical market participant would attribute value
to potential renewals (IFRS 3.29).
Except for this restriction, fair value measurement of reacquired rights generally assumes the perspective
of the typical market participant – despite the fact that both parties to the related contract are combined
within one economic entity as a result of the business combination. Future economic benefit may then be
estimated as the amount of net income a typical market participant would be able to generate as an outside
party to the contract. Except for the ‘time limit’ to the current contractual terms, the choice of measurement
method will follow the same considerations that apply to the underlying intangible asset. For example, if the
reacquired right is a license over a trademark, the right would be measured in a way similar to the value of the
underlying trademark.
4.2 Operating lease contracts; licensing arrangements; other user rights, including
supplier agreements
Operating lease contracts in which the acquiree is the lessee sometimes give rise to identifiable intangible
assets (IFRS 3.B28-30). They may provide future economic benefits from two different perspectives:
•
lease contracts may be considered favorable in comparison to current market terms. This situation
occurs for example when long-term contracts are not automatically adjusted to reflect (say) changes
in a consumer or industry price index. If the terms of an operating lease contract are favourable, an
intangible asset reflects these future economic benefits; if unfavourable, a related liability should be
considered (IFRS 3.B29)
• an operating lease contract may encompass future economic benefits even if the terms of the contract
are in line with current market conditions (sometimes referred to as being ‘at-the-money’ or ‘on-market’).
An on-market lease might have value by virtue of avoiding the time and cost associated with locating and
negotiating an alternative right of use. This may be the case where the acquired business holds a large
number of leases that a typical market participant may find time-consuming to reproduce. Alternatively,
an identifiable intangible asset associated with an operating lease contract may also reflect the leased
asset’s limited availability. IFRS 3.B30 for example explains that “…a lease of gates at an airport or of retail
space in a prime shopping area may provide entry into a market…” and therefore may have value for a
typical market participant.
These same considerations generally apply to the fair value of licensing arrangements, other use rights
and supply contracts. Each of these may be crucial for the acquiree’s business model and represent future
economic benefits. For example, specific supply contracts may provide particular future economic benefits if
the goods or services supplied under the contract are scarce or exclusive. The entity may also benefit from the
condition that a supply contract is not continuously adjusted to reflect market developments.
Generally, a CIDM may be an appropriate way to reflect differences between the terms of the contractual
arrangement under review and current market conditions. A MEEM may be more appropriate where the use
right under review is a very important feature of the business model. The valuation should also reflect the
cost to re-establish the contract under review. A replacement cost measure may be appropriate to reflect
the ‘readiness’ of the contracts. This may be of value to a typical market participant, especially where the
underlying asset is difficult to obtain.
Lessor operating lease
contracts are not
separately considered
as an identifiable
intangible asset in a
business combination.
Operating lease
contracts in which the
acquiree is the lessor
do not give rise to an
intangible asset or a
liability. Instead, the
terms of the lease
are reflected in the
acquisition date-fair-
value of the leased
asset (IFRS 3.B42).
Identifying and valuing intangibles under IFRS 3 2013: Section C 49
The following factors may help to define and assess the economic benefits embodied in use rights and should
be reflected in the fair value estimate of the contract-based intangible asset under review:
•
the subject matter of the contract and how it is related to the business model of the entity
•
the nature and amount of consideration the counterparty is entitled to and whether the contractual payments are
periodically adjusted to market conditions
•
•
time remaining until the next adjustment (if any) and the remaining contractual term of the contractual arrangement
the scarcity or exclusivity of the contract’s underlying resource
• costs incurred to establish the contract under review
• current market terms and conditions for similar contracts.
5. Assembled workforce
The replacement cost method is commonly used to estimate the fair value of the assembled workforce.
This involves constructing a hypothetical scenario in which the acquirer reassembles the acquiree’s
workforce from a zero base. The two main components of this measure are therefore recruitment and
training costs:
• recruitment costs: costs that are incurred to obtain a new employee may include advertising and
•
similar recruitment-related expenditure. Recruitment agency fees should be considered if an entity
would usually use an employment agency to hire new employees. This fee is typically based on the
employee’s starting salary. Additional recruitment costs include selection costs which are incurred to
interview respective candidates and, if applicable, moving and miscellaneous other expenses
training costs: training costs are incurred to train employees and bring them to the level of
performance normally expected from an individual in a given position. One element of training costs
reflects the amount of time inefficiently used by a new employee and his supervisors or colleagues
as a result of training during the new employee’s first few months on the job. The salary of the
new employee and individuals involved is usually used to arrive at a cost estimate, for example by
multiplying relevant salaries with the average degree of inefficiency that is caused by training sessions.
Another element relates to direct training costs that may for example result from using external training
providers or other external resources that are necessary to train the individual (computer software,
books, etc).
The valuation is usually carried out separately for different groups within the assembled workforce. These
groups are usually determined either by reference to the function of the employees (ie R&D, assembly,
administration etc), by reference to the level of employee within an organisation (ie senior management,
middle and lower management, assembly, support staff etc) or by a mixture of both. It is generally expected
that the replacement cost of the assembled workforce will increase with the degree of specialisation and
salary levels. See also Section B.3.2 for an example.
Fair value of assembled
workforce often
necessary to apply the
MEEM
Despite not being
recognisable as a
separate intangible
asset, a valuation of the
assembled workforce
is commonly required
when the MEEM is
applied to estimate
fair value for another
intangible asset. Fair
value measurement
of the workforce is
often used to estimate
contributory asset
charges (see also
Section B.4.4).
50 Identifying and valuing intangibles under IFRS 3 2013: Section C
Service Provider
Case study
Client name:
SERVCORP (Company)
Sector:
Professional services
Acquired:
As part of a business
combination under IFRS 3
by PARENTCO on
30 September 2012
Background
SERVCORP (Company) is a regional provider of professional services.
They were acquired as part of a business combination under IFRS 3 by
PARENTCO on 30 September 2012. The following intangible assets
were identified as of the date of the combination:
• trade name
• service provider number
• customer relationships
• non-compete agreements.
1. Trade name
SERVCORP operates in the Southwest region of the United States and has been a leading provider in its service market
since it was founded in the 1970’s. The Company’s trade name and logo are therefore well-established and recognised
within their industry. The trade name is registered; therefore, it meets the contractual-legal criterion for identifiability. It
was determined the proper method for measurement of the trade name was through the relief-from-royalty method.
Key inputs
After a review of recent similar business combination transactions in the market place, management determined that
an appropriate royalty rate if the trade name were to be licensed to others would be 4%. From the perspective of a
typical market participant, an income tax rate of 30% is estimated as appropriate. Lastly, the asset-specific discount
rate is estimated at 18%.
Measurement
The table on the following page illustrates the fair value measurement of the trade name.
Identifying and valuing intangibles under IFRS 3 2013: Case study 51
Valuation of trade name: relief-from royalty method
3 months
ended
Projected years ending 31 December
Terminal
Year
31 Dec 12
2013
2014
2015
2016
2017
Projected revenues
5,809,000 25,446,000 29,334,000 33,529,000 37,769,000 41,138,000 43,606,280
Pretax relief-from-royalty rate
4.0% 232,360 1,017,840 1,173,360 1,341,160 1,510,760 1,645,520 1,744,251
Less: income tax liability
30.0%
69,708 305,352
352,008
402,348
453,228
493,656
523,275
After tax relief from royalty
162,652 712,488
821,352
938,812 1,057,532 1,151,864 1,220,976
Terminal year relief from royalty
1,220,976
Discount rate
Less: long-term growth
Capitalisation rate
18.0%
3.0%
15.0%
Estimated Terminal value of royalty relief
8,139,839
Present value factor
0.980
0.883
0.749
0.634
0.538
0.456
0.456
Present value relief-from-royalty
159,321 629,312
614,803
595,529
568,507
524,761 3,708,312
Total present value
Present value of residual
Total value
3,092,234
3,708,312
6,800,546
Tax amortisation benefit (TAB)
844,812
Fair value of tradename (rounded) 7,650,000
2. Service provider number
The industry in which SERVCORP operates is regulated by a governmental agency, which limits the number of service
providers that may operate in the geographic region. Therefore, a provider number must be obtained in order to
provide services. In order to apply for a provider number, an entity must first establish a book of business during a trial
period, which is estimated as six months. The costs of providing services during the trial period in order to establish
a book of business are considered by management to represent the primary costs of obtaining the provider number.
Once a provider number has been obtained for a region; however, it may be transferred or sold separately from the
business; it therefore meets the separability criterion for identification as an intangible asset. Due to the time and
cost associated with establishing the business base and applying for a provider number, it is common for market
participants who wish to enter the industry to purchase a provider number as a stand-alone asset. It was determined
that the proper method for measurement of the trade name was through the reproduction cost method.
Key inputs
Management of SERVCORP estimates the direct and indirect costs of providing services during the
six-month trial period to approximate CU1,800,000. From the perspective of a typical market participant, an income
tax rate of 30% is estimated as appropriate. Lastly, the asset-specific discount rate is estimated at 16%.
Measurement
The table below illustrates the fair value measurement of the service provider number.
Valuation of service provider number – reproduction cost method (in CUs)
Estimated pre-tax cost to replace
Less: taxes
Estimated after-tax cost to replace
Tax amortisation benefit (TAB)
Estimated fair value of service provider number (rounded)
1,800,000
30%
540,000
1,260,000
171,981
1,430,000
52 Identifying and valuing intangibles under IFRS 3 2013: Case study
3. Customer relationships
The services that SERVCORP provides to its customers are long-term in nature; however, they do not frequently
enter into contract agreements. The Company’s customer service department however is responsible for building
and maintaining the relationship with the customer contacts and must be in weekly communication with them in order
to coordinate delivery of the services and maintaining customer satisfaction. Though non-contractual in nature, the
customer relationships are considered to be separately identifiable. The multi-period excess earnings method (MEEM)
is considered as the most appropriate method of measuring the fair value of the customer relationships.
Key inputs
In order to determine the appropriate cash flows attributable to the existing customer relationships a number of
adjustments have to be made to the Company’s overall projected revenues:
1. removal of revenues not attributable to customer relationships: although SERVCORP primarily provides
services to customers on a recurring, long-term basis, they do occasionally receive requests
for non-recurring services. In addition, some revenue is derived from other sources (eg internet or walk-ins)
outside of the customer service department
2. removal of revenues attributable to new customer relationships: the Company’s PFI includes projected revenues
that are expected to be derived from customers that are added in a future period. Since these relationships do
not exist as of the date of the business combination, they must be removed from the calculation.
In addition to the above adjustments, the customer relationships calculation must be adjusted to take into account
contributory asset charges, which include but are not limited to certain of the other intangible assets. Royalties
of 4% of revenues assumed to be paid for use of the trade name (see above) must also first be deducted. Other
CAC’s include:
• net working capital
• fixed assets
• service provider number (see Section 2 of this Case Study)
• non-compete agreements (see Section 4 of this Case Study)
• assembled workforce (see below).
The asset-specific discount rate for the customer relationship intangible asset is 17.5%.
Contributory asset – assembled workforce
In order to derive the contributory asset charge for the related assembled workforce, the below calculation is
performed to determine the expected value of the intangible asset:
Group
Average
Training
Lost Average annual Number of
Cost to
recruiting
cost productivity
compensation employees
reproduce
(CU/person)
(CU/person)
(CU/person)
(CU/person)
(CU total/group)
Senior management
125,000
20,000
Customer service personnel
Administration
Other support staff
–
–
–
5,000
5,000
3,500
20%
15%
5%
0%
125,000
100,000
70,000
50,000
1
8
6
5
Total cost to reproduce assembled workforce
Income tax (30%)
Tax amortisation benefit (TAB)
Indicative value of workforce
Measurement
The table on the following page illustrates the fair value measurement of the customer relationships.
170,000
160,000
51,000
17,500
398,500
(119,550)
35,537
314,487
Identifying and valuing intangibles under IFRS 3 2013: Case study 53
Valuation of customer relationships: multi-period excess earnings method (MEEM)
3 months
Projected years ending 31 December
ended
31 Dec 12
2013
2014
2015
2016
Projected revenues
5,809,000 25,446,000 29,334,000 33,529,000 37,769,000
Revenues not attributable to customer relationships
871,350 5,089,200
5,866,800
6,705,800
7,553,800
Revenues attributable to customer relationships
4,937,650 20,356,800 23,467,200 26,823,200 30,215,200
Revenues attributable to new customer relationships
– 1,663,200
3,651,984
6,017,223
8,368,924
Revenues attributable to existing relationships
4,937,650 18,693,600 19,815,216 20,805,977 21,846,276
Beginning relationships
Existing relationship retention curve
7.7%
Ending relationships
Average remaining relationships
100.0%
100.0%
0.0%
100.0%
100.0%
7.7%
92.3%
96.2%
92.3%
7.7%
84.6%
88.5%
84.6%
7.7%
76.9%
80.8%
76.9%
7.7%
69.2%
73.1%
Estimated revenues from existing relationships
4,937,650 17,974,615 17,528,845 16,804,828 15,964,586
Charge for trade name royalty rate
4.0%
197,506
718,985
701,154
672,193
638,583
Revenues after royalties
4,740,144 17,255,631 16,827,691 16,132,634 15,326,003
Operating expenses
3,704,840 13,480,962 13,146,634 12,603,621 11,973,440
Earnings before interest, taxes, depreciation
and amortisation
1,035,304 3,774,669
3,681,057
3,529,014
3,352,563
Provision for taxes
30.0%
310,591 1,132,401
1,104,317
1,058,704
1,005,769
Invested capital net income
724,713 2,642,268
2,576,740
2,470,310
2,346,794
Contributory asset charges
Net working capital
Fixed assets
Service provider number
Non-compete agreements
Assembled workforce
0.53%
0.07%
0.66%
0.35%
0.15%
(26,170)
(3,456)
(95,265)
(12,582)
(92,903)
(12,270)
(89,066)
(11,763)
(84,612)
(11,175)
(32,588)
(118,632)
(115,690)
(110,912)
(105,366)
(17,282)
(7,406)
(62,911)
(26,962)
(61,351)
(26,293)
(58,817)
(25,207)
(55,876)
(23,947)
Total contributory asset charges
(86,903)
(316,353)
(308,508)
(295,765)
(280,977)
Earnings attributable to customer relationships
637,810 2,325,915
2,268,233
2,174,545
2,065,817
Present value factor
17.5%
0.923
0.886
0.754
0.642
0.546
Present value of customer relationship earnings
588,400 2,060,941
1,710,493
1,395,610
1,128,366
Total present value of future cash flows
Tax amortisation benefit (TAB)
10,227,225
1,302,905
Fair value of customer relationships (rounded)
11,530,000
54 Identifying and valuing intangibles under IFRS 3 2013: Case study
Projected years ending 31 December
2017
2018
2019
2020
2021
2022
2023
2024
2025
41,138,000 43,606,280 45,786,594 47,618,058 49,046,599 50,517,997 52,033,537 53,594,544 55,202,380
8,227,600 8,721,256 9,157,319
9,523,612
9,809,320 10,103,599 10,406,707 10,718,909 11,040,476
32,910,400 34,885,024 36,629,275 38,094,446 39,237,279 40,414,398 41,626,830 42,875,635 44,161,904
9,971,811 11,028,891 11,818,897 12,291,653 12,531,388 12,773,801 13,018,812 13,266,336 13,516,280
22,938,589 23,856,133 24,810,378 25,802,793 26,705,891 27,640,597 28,608,018 29,609,299 30,645,624
69.2%
7.7%
61.5%
65.4%
61.5%
7.7%
53.8%
57.7%
53.8%
7.7%
46.2%
50.0%
46.2%
7.7%
38.5%
42.3%
38.5%
7.7%
30.8%
34.6%
30.8%
7.7%
23.1%
26.9%
23.1%
7.7%
15.4%
19.2%
15.4%
7.7%
7.7%
11.5%
7.7%
7.7%
0.0%
3.8%
14,998,308 13,763,154 12,405,189 10,916,566
9,244,347 7,441,699
5,501,542
3,416,458 1,178,678
599,932
550,526
496,208
436,663
369,774
297,668
220,062
136,658
47,147
14,398,376 13,212,628 11,908,981 10,479,904
8,874,573 7,144,031
5,281,480
3,279,799 1,131,531
11,248,731 10,322,365 9,303,892
8,187,425
6,933,260 5,581,274
4,126,156
2,562,343
884,008
3,149,645 2,890,262 2,605,090
2,292,479
1,941,313 1,562,757
1,155,324
717,456
247,522
944,893
867,079
781,527
687,744
582,394
468,827
346,597
215,237
74,257
2,204,751 2,023,184 1,823,563
1,604,735
1,358,919 1,093,930
808,727
502,219
173,266
(79,491)
(72,945)
(65,748)
(57,858)
(48,995)
(39,441)
(29,158)
(18,107)
(6,247)
(10,499)
(9,634)
(8,684)
(7,642)
(6,471)
(5,209)
(3,851)
(2,392)
(825)
(98,989)
(90,837)
(81,874)
(72,049)
(61,013)
(49,115)
(36,310)
(22,549)
(7,779)
–
–
–
–
–
–
–
–
–
(22,497)
(20,645)
(18,608)
(16,375)
(13,867)
(11,163)
(8,252)
(5,125)
(1,768)
(211,476)
(194,060)
(174,913)
(153,924)
(130,345)
(104,928)
(77,572)
(48,172)
(16,619)
1,993,275 1,829,123 1,648,650
1,450,812
1,228,574
989,002
731,155
454,047
156,646
0.465
0.396
0.337
0.287
0.244
0.208
0.177
0.150
0.128
926,590
723,644
555,102
415,736
299,619
205,271
129,152
68,258
20,042
Identifying and valuing intangibles under IFRS 3 2013: Case study 55
4. Non-compete agreements
In conjunction with the acquisition agreement, certain members of SERVCORP’s management team
were required to enter covenants not to compete in the event that they leave the combined entity. The
non-compete agreements are deemed to be identifiable for measurement given their nature as a contractual-legal
agreement.
Key inputs
In order to recognise the probability of competition as well as the effect of beginning competition in different years,
the expert assessed four possible scenarios, based on discussion with management of SERVCORP and PARENTCO,
and weighted the resulting value estimate based on the probability of occurrence. Each scenario reflects the amount
of sales that could be captured depending on whether the covered employee is competing and when he/she decided
to compete. The scenarios are summarised as follows:
1. the first scenario assumes no competition and is the base calculation for the model
2. the second scenario assumes that competition begins as soon as possible and is able to capture a small amount
of sales in the first year. SERVCORP would be expected to gradually regain business in the years beyond as the
Company begins to combat the new competition. The value of this scenario is the present value of the cash flows
in Scenario 1 less the present value of the cash flows from Scenario 2. This scenario is perceived by management
to be the most likely if the covered persons chose to compete
3. the third scenario assumes that competition begins in year two after the valuation date. The competition is
assumed to have the same impact as in Scenario 2; however, the effect is delayed. Consistent with Scenario 2,
SERVCORP would be expected to be able to combat the new competition beyond year two. The value of this
scenario is the present value of the cash flows in Scenario 1 less the present value of the cash flows from
Scenario 3
4. the fourth scenario assumes that competition begins in year three after the valuation date. The effect
on SERVCORP’s sales is similar but delayed. The value of this scenario is the present value of the cash flows in
Scenario 1 less the present value of the cash flows from Scenario 4.
The asset-specific discount rate for the non-compete agreements is assumed to be 18.5%. From the perspective of a
typical market participant, an income tax rate of 30% is estimated as appropriate.
Measurement
The table on the following page illustrates the fair value measurement of the non-compete agreements.
56 Identifying and valuing intangibles under IFRS 3 2013: Case study
Valuation of non-compete agreements – comparative income differential method (CIDM)
With NCA – Base case (Scenario 1)
3 months
ended
31 Dec 12
Negative impact of competition
0.0%
Year 1
0.0%
Year 2
0.0%
Year 3
0.0%
Year 4
0.0%
Year 5
0.0%
Revenues
5,809,000 25,446,000 29,334,000 33,529,000 37,769,000 41,138,000
Less: impact of competition
–
–
–
–
–
–
Adjusted revenue
5,809,000 25,446,000 29,334,000 33,529,000 37,769,000 41,138,000
x Operating margin
Operating income
Income taxes @
Net income
+ Depreciation
- Capital expenditure
25.0%
16.4%
17.3%
18.2%
20.5%
22.1%
1,452,250
4,173,144
5,074,782
6,102,278
7,742,645 9,091,498
30.0%
435,675
1,251,943
1,522,435
1,830,683
2,322,794 2,727,449
1,016,575
2,921,201
3,552,347
4,271,595
5,419,852 6,364,049
181,659
729,778
738,528
747,278
756,028
756,635
(176,000)
(700,000)
(700,000)
(700,000)
(700,000)
(700,000)
+/- Change in working capital
(75,000)
(383,261)
(388,800)
(419,500)
(424,000)
(336,900)
Net cash flow
947,234
2,567,717
3,202,075
3,899,372
5,051,879 6,083,784
Present value factor
18.5%
0.979
0.880
0.743
0.627
0.529
0.466
Present value of net cash flow
927,347
2,260,781
2,379,164
2,444,946
2,673,063 2,834,270
Total present value of net cash flow
13,519,570
Without NCA – competition begins in Yr 1 (Scenario 2)
3 months
ended
31 Dec 12
Negative impact of competition
0.0%
Year 1
-1.0%
Year 2
-2.5%
Year 3
-5.0%
Year 4
-7.5%
Year 5
-10.0%
Revenues
5,809,000 25,446,000 29,334,000 33,529,000 37,769,000 41,138,000
Less: impact of competition
–
(254,460)
(733,350)
(1,676,450)
(2,832,675)
(4,113,800)
Adjusted revenue
5,809,000 25,191,540 28,600,650 31,852,550 34,936,325 37,024,200
x Operating margin
Operating income
Income taxes @
Net income
+ Depreciation
- Capital expenditure
25.0%
16.4%
17.3%
18.2%
20.5%
22.1%
1,452,250
4,131,413
4,947,912
5,797,164
7,161,947 8,182,348
30.0%
435,675
1,239,424
1,484,374
1,739,149
2,148,584 2,454,704
1,016,575
2,891,989
3,463,539
4,058,015
5,013,363 5,727,644
181,659
729,778
738,528
747,278
756,028
756,635
(176,000)
(700,000)
(700,000)
(700,000)
(700,000)
(700,000)
+/- Change in working capital
(75,000)
(383,261)
(388,800)
(419,500)
(424,000)
(336,900)
Net cash flow
947,234
2,538,505
3,113,266
3,685,792
4,645,390 5,447,379
Present value factor
18.5%
0.979
0.880
0.743
0.627
0.529
0.466
Present value of net cash flow
927,347
2,235,061
2,313,178
2,311,029
2,457,980 2,537,786
Total present value of net cash flow
12,782,382
Identifying and valuing intangibles under IFRS 3 2013: Case study 57
Without NCA – competition begins in Yr 2 (Scenario 3)
3 months
ended
31 Dec 12
Negative impact of competition
0.0%
Year 1
0.0%
Year 2
-1.0%
Year 3
-2.5%
Year 4
-5.0%
Year 5
-7.5%
Revenues
5,809,000 25,446,000 29,334,000 33,529,000 37,769,000 41,138,000
Less: impact of competition
–
–
(293,340)
(838,225)
(1,888,450)
(3,085,350)
Adjusted revenue
5,809,000 25,446,000 29,040,660 32,690,775 35,880,550 38,052,650
x Operating margin
Operating income
Income taxes @
Net income
+ Depreciation
- Capital expenditure
25.0%
16.4%
17.3%
18.2%
20.5%
22.1%
1,452,250
4,173,144
5,024,034
5,949,721
7,355,513 8,409,636
30.0%
435,675
1,251,943
1,507,210
1,784,916
2,206,654 2,522,891
1,016,575
2,921,201
3,516,824
4,164,805
5,148,859 5,886,745
181,659
729,778
738,528
747,278
756,028
756,635
(176,000)
(700,000)
(700,000)
(700,000)
(700,000)
(700,000)
+/- Change in working capital
(75,000)
(383,261)
(388,800)
(419,500)
(424,000)
(336,900)
Net cash flow
947,234
2,567,717
3,166,551
3,792,582
4,780,886 5,606,480
Present value factor
18.5%
0.979
0.880
0.743
0.627
0.529
0.466
Present value of net cash flow
927,347
2,260,781
2,352,770
2,377,987
2,529,674 2,611,907
Total present value of net cash flow
13,060,466
Without NCA – competition begins in Yr 3 (Scenario 4)
3 months
ended
31 Dec 12
Negative impact of competition
0.0%
Year 1
0.0%
Year 2
0.0%
Year 3
-1.0%
Year 4
-2.5%
Year 5
-5.0%
Revenues
5,809,000 25,446,000 29,334,000 33,529,000 37,769,000 41,138,000
Less: impact of competition
–
–
–
(335,290)
(944,225)
(2,056,900)
Adjusted revenue
5,809,000
25,446,000 29,334,000 33,193,710 36,824,775 39,081,100
x Operating margin
Operating income
Income taxes @
Net income
+ Depreciation
- Capital expenditure
25.0%
16.4%
17.3%
18.2%
20.5%
22.1%
1,452,250
4,173,144
5,074,782
6,041,255
7,549,079 8,636,923
30.0%
435,675
1,251,943
1,522,435
1,812,377
2,264,724 2,591,077
1,016,575
2,921,201
3,552,347
4,228,879
5,284,355 6,045,846
181,659
729,778
738,528
747,278
756,028
756,635
(176,000)
(700,000)
(700,000)
(700,000)
(700,000)
(700,000)
+/- Change in working capital
(75,000)
(383,261)
(388,800)
(419,500)
(424,000)
(336,900)
Net cash flow
947,234
2,567,717
3,202,075
3,856,656
4,916,383 5,765,581
Present value factor
18.5%
0.979
0.880
0.743
0.627
0.529
0.466
Present value of net cash flow
927,347
2,260,781
2,379,164
2,418,162
2,601,368 2,686,028
Total present value of net cash flow
13,272,851
58 Identifying and valuing intangibles under IFRS 3 2013: Case study
Probability Weighted Present Value of Non-Compete Scenarios
Multi-Scenario With-Without Summary PV Cash Flows
PV Cash Flows
WITH
WITHOUT
PV of Lost
Probability of
Weighted
Agreement
Agreement Cash Flow
Competition
Value
Scenario 1: No Competition (Base Case)
13,519,570
13,519,570
–
Scenario 2: Competition Begins in Year 1
13,519,570
12,782,382
737,188
Scenario 3: Competition Begins in Year 2
13,519,570
13,060,466
459,104
Scenario 4: Competition Begins in Year 3
13,519,570
13,272,851
246,719
70.0%
15.0%
10.0%
5.0%
PV of cash flow protected
Tax amortisation benefit (TAB)
Fair value of non-compete agreement
Number of covered employees
Total fair value of non-compete agreements (rounded)
–
110,578
45,910
12,336
168,824
20,526
189,350
5
950,000
5. Summary of intangible assets’ fair values
The summary of fair values of the identifiable intangible assets under IFRS 3 for the SERVCORP business combination
as of 30 September 2012 is as follows:
Identifiable intangible asset
Trade name
Service provider number
Customer relationships
Non-compete agreements
Fair value (CUs)
7,650,000
1,430,000
11,530,000
950,000
The above table is not a comprehensive allocation of the purchase price for SERVCORP due to the tangible assets and
liabilities acquired (assumed) and goodwill being out of scope of this Case Study.
Identifying and valuing intangibles under IFRS 3 2013: Case study 59
Notes
60 Identifying and valuing intangibles under IFRS 3 2013
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SEPTEMBER 6, 2017
VALUATIONS IN FINANCIAL
REPORTING VALUATION ADVISORY 3:
THE MEASUREMENT AND
APPLICATION OF MARKET
PARTICIPANT ACQUISITION
PREMIUMS
COPYRIGHT © 2017 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
VFR Valuation Advisory #3
The Measurement and Application of Market Participant Acquisition Premiums
This communication is for the purpose of issuing voluntary guidance on recognized
valuation methods and techniques.
Date Issued: September 6, 2017
Application: Business Valuation, Intangible Assets
Background: In recent years there have been increased requirements in the identification and
recognition of assets and liabilities measured at fair value in financial statements. These
requirements, promulgated by the Financial Accounting Standards Board (FASB), include:
• Statement of Financial Accounting Standards No. 141(R), predecessor to Accounting
Standards Codification (ASC) 805 Business Combinations; and
• FASB Statement No. 142, predecessor to ASC 350 Intangibles - Goodwill and Other
(ASC 350) and Accounting Standards Update (ASU) 2011-08.
Moreover, there has been increased focus on fair value measurement since the FASB issued
Statement No. 157 (predecessor to ASC 820 Fair Value Measurement) in 2006 and ASU
2011-04 in 2011.
Furthermore, the International Accounting Standards Board (IASB) has issued International
Financial Reporting Standard (IFRS) 3 (revised) (IFRS 3R) Business Combinations (IFRS 3R)
and IFRS 13 Fair Value Measurement, both of which are largely similar to the statements issued
by the FASB.
Like ASC 350, International Accounting Standard 36 Impairment of Assets (IAS 36) includes the
testing of goodwill for impairment. However, these standards are not converged, and the specific
procedures of the goodwill impairment test are different. The measurements used to determine
the recoverable amount, which is then compared to the carrying amount, differ; for example
ASC 350 uses Fair Value whereas IAS 36 uses the lower of Value in Use or Fair Value Less
Costs of Disposal. Further discussion of the differences between these accounting models is
beyond the scope of this publication. Notwithstanding, concepts covered in this VFR Valuation
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
1
Advisory #3 may be applicable on a facts and circumstances basis when fair value is being
determined in IAS 36.
During the creation of this document, members of the International Valuation Standards Council
(IVSC) participated in certain discussions.
Because of the need for financial statements to be both reliable and relevant, valuation practices
must provide reasonably consistent and supportable fair value conclusions. To this end, it is
believed that guidance regarding best practices on certain specific valuation topics would be
helpful. The topics are selected based on those in which the greatest diversity of practice has
been observed. To date, The Appraisal Foundation has issued two Valuations in Financial
Reporting (VFR) Advisories as follows: VFR Advisory #1, The Identification of Contributory
Assets and Calculation of Economic Rents (May 31, 2010); and VFR Advisory #2, The
Valuation of Customer Related Assets (June 15, 2016). In addition, guidance is currently under
development on the topic of valuing contingent consideration.
This document presents helpful guidance for those that are preparing fair value measurements;
however, this Advisory is not intended to be an authoritative valuation standard. The valuation of
assets is a complicated exercise that requires significant judgment. The Working Group believes
that consideration of the facts and circumstances related to the asset(s) that are being valued may
sometimes support a departure from the recommendations in this Advisory. This Advisory seeks
to present views on how to approach and apply certain aspects of the valuation process
appropriate for measuring the fair value of controlling interests.
This VFR Advisory has been developed for measuring fair value for financial reporting and is
not intended for other valuation contexts.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
2
The Appraisal Foundation wishes to express its utmost gratitude to the Working Group on The
Measurement and Application of Market Participant Acquisition Premiums for volunteering
their time and expertise in contributing to this Advisory. Specifically, sincere thanks to the
following individuals:
Working Group on
The Measurement and Application of Market Participant Acquisition Premiums
Manish Choudhary
Dayton D. Nordin
Deloitte Financial Advisory Services LLP –
New York, NY
Andrew S. Fargason
Stout – Atlanta, GA
Travis W. Harms
Ernst & Young – Boston, MA
BJ Orzechowski
KPMG LLP – Philadelphia, PA
Carla G. Glass, Oversight and Facilitator
for The Appraisal Foundation
Mercer Capital – Memphis, TN
Marcum LLP – New Haven, CT
Subject Matter Expert Group on Best Practices for Valuations in Financial Reporting
Jay E. Fishman, Co-Chair - Financial
Research Associates
Carla G. Glass, Co-Chair - Marcum LLP
Anthony Aaron – University of Southern
California
Paul Barnes - Duff & Phelps, LLC
John Glynn - PricewaterhouseCoopers LLP
(Retired)
Matt Pinson - PricewaterhouseCoopers LLP
Contributors and Special Thanks
Chad Arcinue - Ernst & Young, New York, NY
The Appraisal Foundation Staff
David Bunton, President
John S. Brenan, Director of Appraisal Issues
Paula Douglas Seidel, Board and Communications Program Manager
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
3
The views set forth in this Advisory are the collective views of the members of this Working
Group and do not necessarily reflect the views of any of the firms that the Working Group
members are associated with.
This Advisory was approved for publication by the Board of Trustees of The Appraisal
Foundation on September 6, 2017. The reader is informed that the Board of Trustees defers to
the members of the Working Group for expertise concerning the technical content of the
document.
The Appraisal Foundation served as a sponsor and facilitator of this Working Group. The
Appraisal Foundation is the nation’s foremost authority on the valuation profession. The
organization sets the Congressionally authorized standards and qualifications for real estate
appraisers, and provides voluntary guidance on recognized valuation methods and techniques
for all valuation professionals. This work advances the profession by ensuring appraisals are
independent, consistent, and objective. More information on The Appraisal Foundation is
available at www.appraisalfoundation.org.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
4
TABLE OF CONTENTS
BACKGROUND ------------------------------------------------------------------------------------------------------------------- 7
INTRODUCTION AND SCOPE ----------------------------------------------------------------------------------------------- 8
MARKET PARTICIPANT ACQUISITION PREMIUM ----------------------------------------------------------------- 9
CONCEPTS -------------------------------------------------------------------------------------------------------------------------------------- 9
DEFINITION ---------------------------------------------------------------------------------------------------------------------------------- 10
CONTROL AND MARKETABILITY -------------------------------------------------------------------------------------------------------- 10
ILLUSTRATIVE EXAMPLES ---------------------------------------------------------------------------------------------------------------- 11
CONCLUDING OBSERVATIONS ----------------------------------------------------------------------------------------------------------- 12
CONCEPTUAL CONSIDERATIONS --------------------------------------------------------------------------------------- 13
PREROGATIVES OF CONTROL ------------------------------------------------------------------------------------------------------------ 13
ECONOMIC BENEFITS THAT SUPPORT MPAP ---------------------------------------------------------------------------------------- 14
ENHANCED CASH FLOWS ----------------------------------------------------------------------------------------------------------------- 14
LOWER REQUIRED RATE OF RETURN -------------------------------------------------------------------------------------------------- 16
OTHER KEY POINTS ------------------------------------------------------------------------------------------------------------------------ 17
BUSINESS CHARACTERISTICS INFLUENCING MARKET PARTICIPANT ACQUISITION
PREMIUM ------------------------------------------------------------------------------------------------------------------------- 19
ACQUISITION ACTIVITY IN THE INDUSTRY -------------------------------------------------------------------------------------------- 19
STAGE IN COMPANY LIFE CYCLE ------------------------------------------------------------------------------------------------------- 19
MARKET PARTICIPANT ATTRIBUTES --------------------------------------------------------------------------------------------------- 20
SIZE OF MARKET PARTICIPANTS RELATIVE TO SUBJECT ENTITY --------------------------------------------------------------- 21
BALANCE OF INFORMATION -------------------------------------------------------------------------------------------------------------- 21
CAPITAL STRUCTURE OF SUBJECT ENTITY ------------------------------------------------------------------------------------------- 23
MANAGEMENT OBJECTIVES -------------------------------------------------------------------------------------------------------------- 23
QUALITY OF MANAGEMENT ------------------------------------------------------------------------------------------------------------- 23
REGULATORY FACTORS ------------------------------------------------------------------------------------------------------------------- 24
CORPORATE BY-LAWS AND GOVERNING DOCUMENTS ---------------------------------------------------------------------------- 24
TRANSACTION STRUCTURE -------------------------------------------------------------------------------------------------------------- 25
SUMMARY ------------------------------------------------------------------------------------------------------------------------------------ 25
CONCLUSIONS ------------------------------------------------------------------------------------------------------------------------------- 26
ANALYTICAL METHODS ---------------------------------------------------------------------------------------------------- 27
EXPRESSING THE MARKET PARTICIPANT ACQUISITION PREMIUM -------------------------------------------------------------- 27
ANALYZING HISTORICAL PREMIUM AND TRANSACTION DATA ------------------------------------------------------------------ 29
ASSESSING THE UNDERLYING DATA SET – TRANSACTION DATA --------------------------------------------------------------- 29
OTHER CONSIDERATIONS – HISTORICAL PREMIUM DATA ------------------------------------------------------------------------ 31
LIMITATIONS INHERENT IN OBSERVED PREMIUM AND TRANSACTION DATA ------------------------------------------------- 32
ASSESSING THE REASONABLENESS OF THE CONCLUDED MARKET PARTICIPANT ACQUISITION
PREMIUM ------------------------------------------------------------------------------------------------------------------------------------- 33
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
5
THE FAIR VALUE CONTEXT ----------------------------------------------------------------------------------------------- 37
THE FAIR VALUE DEFINITION ----------------------------------------------------------------------------------------------------------- 37
EXIT PRICE ----------------------------------------------------------------------------------------------------------------------------------- 37
PRINCIPAL (OR MOST ADVANTAGEOUS) MARKET ---------------------------------------------------------------------------------- 37
MARKET PARTICIPANTS ------------------------------------------------------------------------------------------------------------------ 38
HIGHEST AND BEST USE ------------------------------------------------------------------------------------------------------------------ 39
ASSET CHARACTERISTICS ---------------------------------------------------------------------------------------------------------------- 39
FAIR VALUE MEASUREMENTS OF CONTROLLING INTERESTS IN BUSINESS ENTERPRISES --------------------------------- 39
GOODWILL IMPAIRMENT TESTING ------------------------------------------------------------------------------------------------------ 40
PORTFOLIO VALUATION ------------------------------------------------------------------------------------------------------------------ 40
ACQUISITION METHOD FOR STEP ACQUISITIONS ------------------------------------------------------------------------------------ 40
SELECTING AND ASSESSING MARKET PARTICIPANT ACQUISITION PREMIUMS –
EXAMPLES ------------------------------------------------------------------------------------------------------------------------ 42
SUMMARY ------------------------------------------------------------------------------------------------------------------------ 55
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
6
BACKGROUND
Premiums for control have long been a focus in business valuation.
Through the early 1990s, it was generally accepted that the publicly traded price of a company’s
shares represented the value of a minority interest and that, if the goal was to value a control
interest, a “premium for control” would be added to the value of equity indicated by that publicly
traded price. That premium generally came from market evidence in which the price paid to
acquire an entire company was compared to the publicly traded price of that same company’s
shares prior to the acquisition.
However, in the late 1990s, this concept came into question and views have since been changing.
Various points have been made regarding why the control value of an entity might be no greater
than that indicated by its publicly traded price.
In any case, it has become widely accepted that the market evidence supplied by comparing the
acquisition price to the publicly traded price does not represent a premium for conceptual control
but, rather, represents a premium linked to actual changes that can be made by exercising that
control. Control, and whether one has it, is not really the focal point. What matters is that, after
an acquisition, the acquired company is now under different management/stewardship. A price
higher than the publicly traded price might be reasonable if the new management and/or
combined entity expect(s) improved cash flow or growth or reduced risk. If no improvements or
risk reduction could reasonably be expected, there may be little ability for an acquirer to pay a
price higher than the publicly traded price and still generate a reasonable return on its investment.
In such cases, the control value may approximate the publicly traded price.
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
7
INTRODUCTION AND SCOPE
21
22
23
24
25
26
27
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29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
This VFR Advisory sets forth best practices for certain issues encountered in measuring the fair
value of controlling interests in business enterprises for financial reporting purposes. When
valuing controlling interests in business enterprises, valuation specialists often reference the
concept generally referred to as the control premium. The Appraisal Foundation’s Subject Matter
Expert Group on Best Practices for Valuations in Financial Reporting has identified the use of
control premiums in fair value measurement as an area of considerable diversity in appraisal
practice.
The most common instances of such fair value measurements include Step 1 of the goodwill
impairment test, portfolio valuation for investment companies, and application of the acquisition
method of business combinations for step acquisitions. Of these, the Working Group believes
Step 1 of the goodwill impairment test is most prevalent.
In a 2008 Securities and Exchange Commission (SEC) speech, the topic of control premiums
was raised. It was stated that, in cases where higher control premiums are used, the level of
documentation required to support the control premium would also increase.1
In fulfilling its mandate to provide best practices in the context of measuring fair value for
financial reporting purposes, the Working Group has elected to introduce the term Market
Participant Acquisition Premium (MPAP). The purpose of introducing this new term is twofold:
(1) to emphasize the importance of the market participants’ perspective when measuring fair
value; and (2) to distinguish this premium from the more general (and occasionally controversial)
notion of the control premium.
The best practices presented in this VFR Advisory have been developed for measuring fair value
for financial reporting and are not intended for other valuation contexts.
This VFR Advisory is the result of deliberations by the Working Group and input received from
interested parties.
1 Robert G. Fox III, “Speech by SEC Staff: Remarks before the 2008 AICPA National Conference on
Current SEC and PCAOB Developments,” December 8, 2008, transcript, https://www.sec.gov/
news/speech/2008/spch120808rgf.htm.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
8
MARKET PARTICIPANT ACQUISITION PREMIUM
45
Concepts
46
47
48
49
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51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
Valuation specialists have long believed that the value of a business ownership interest is
influenced by the degree of control available to the subject interest’s owner. The International
Glossary of Business Valuation Terms2 defines control as “the power to direct the management
and policies of a business enterprise.”3 Both intuition and empirical observation suggest that the
presence (or absence) of the so-called prerogatives of control may influence the value of a
business ownership interest. In short, one would usually prefer to exercise control than not. As a
result, investors might be willing to pay more for a controlling interest than for an otherwise
comparable noncontrolling interest in the same enterprise.
To induce a rational investor to pay more for a controlling interest, the prerogatives of control
must give rise to the potential for incremental economic benefits. In other words, the prerogatives
of control have little inherent value, but rather have value to the extent that their exercise
enhances the economic benefits available to the owner of the subject controlling interest. Control
may be valuable if the exercise of control will enhance the enterprise’s cash flows and/or reduce
the enterprise’s risk. The International Glossary of Business Valuation Terms defines a control
premium as “an amount or percentage by which the pro rata value of a controlling interest
exceeds the pro rata value of a noncontrolling interest in a business enterprise, to reflect the value
of control.”
Historically, the concept and/or measurement of the control premium has proven to be vexing
and contentious to valuation specialists. Those of a more empirical disposition point to the range
of premiums observed in closed transactions as a starting point for analysis, while others observe
that the much larger population of public companies that are not acquired each year supports the
theory that control premiums for most publicly traded companies either do not exist or are too
small to justify the costs and uncertainties associated with an attempted acquisition. In the
context of fair value measurement, the Working Group desires to reorient discussion and analysis
to the reasonable expectations of the relevant pool of market participants regarding cash flow
enhancement and risk reduction at the measurement date.
2 The International Glossary of Business Valuation Terms contains valuation terms and definitions adopted
by five North American professional organizations that recognize business valuation as a professional
discipline: American Institute of Certified Public Accountants, American Society of Appraisers, National
Association of Certified Valuation Analysts, The Canadian Institute of Chartered Business Valuators, and
The Institute of Business Appraisers.
3 The Working Group believes that this definition is consistent with instances where definitions of control
appear in U.S. Generally Accepted Accounting Principles.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
9
72
Definition
73
74
75
76
77
78
79
80
81
82
83
84
85
86
In this VFR Advisory the Working Group has introduced the MPAP, defined as the difference
between: (1) the pro rata fair value of the subject controlling interest; and (2) its foundation.
Foundation is measured with respect to the current stewardship of the enterprise. In other words,
the foundation contemplates that the prerogatives of control will continue to reside with the
existing controlling shareholder or group of shareholders. The Working Group believes that
valuation specialists most commonly associate the foundation with the pro rata fair value of
marketable, noncontrolling interests in the enterprise. Therefore, for publicly traded companies,
the equity foundation is equal to the quoted market price for the company’s shares. Foundation
value does not give consideration to discounts for lack of marketability/liquidity.
However, while the preceding describes an MPAP Equity Foundation concept, later in this
Advisory an alternative way to think about the MPAP is introduced. It proposes that instead of
utilizing the Equity Foundation to determine an MPAP, usage of a Total Invested Capital (TIC)
Foundation may be more appropriate. (For clarity and emphasis, this use of the word
“Foundation” will be capitalized in subsequent sections.)
87
Control and Marketability
88
89
90
91
92
93
94
95
96
97
98
99
The MPAP definition does not ascribe a particular degree of marketability to the subject
controlling interest. The issue of marketability for controlling interests is a source of diversity in
practice, as some valuation specialists apply discounts for lack of marketability to derive the fair
value of controlling interests in privately held companies, while others do not. The Working
Group believes in most cases sellers would have access to a market as a forum to transact.
Among the prerogatives of control is the discretion to pursue an orderly sales process in order to
realize the (undiscounted) value of the interest while enjoying the benefits of ownership.
Although transaction costs would not be considered part of fair value, fair value contemplates the
usual and customary marketing activities for such interests. Controlling interests should not be
held to the same standard of marketability as publicly traded equities because the markets (and
associated marketing periods) differ. For controlling interests in business enterprises, the usual
and customary marketing activities may be time consuming.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
10
100
Illustrative Examples
101
102
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106
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115
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118
119
120
121
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128
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131
132
133
134
135
136
Two examples serve to clarify the MPAP definition. First, consider a business enterprise that is
not publicly traded. The company’s founder owns 70 percent of the outstanding shares and
continues to exercise control over the enterprise. The remaining 30 percent of the outstanding
shares are held by a number of investors, none of whom own more than 5 percent. Despite the
availability of numerous investment opportunities with indicated positive net present values, the
founder demonstrates little interest in growth and is averse to the use of debt financing. The price
per share paid by market participants for a controlling interest is likely to exceed that paid for a
noncontrolling (albeit hypothetically marketable) interest reflecting current stewardship of the
company. In other words, there is likely to be an MPAP. Its magnitude likely will be influenced
by the perceived ability of market participants to exercise the prerogatives of control to increase
the cash flows and/or reduce the discount rate applicable to the subject interest. Available
strategies include making investments to spur revenue and earnings growth (thereby potentially
increasing cash flow), and employing a more typical financing mix for the industry (thereby
reducing the weighted average cost of capital). Some market participants may also expect cost
savings from eliminating redundancies. For privately held companies without near term liquidity
expectations—much more so than publicly traded companies—there might also be cost savings
from adjusting compensation and other costs to market rates.4
Second, consider a business enterprise that is publicly traded. The business is generally believed
to be well managed, reporting operating margins in line with industry peers. The company has
created and marketed a unique technology and has generated significant historical revenue
growth. In this case, opportunities to generate economic benefits by exercising the prerogatives
of control are more limited. However, market participants may own complementary technologies
that, if marketed alongside that of the subject entity, would increase revenue growth.
Alternatively, market participants may have existing distribution networks capable of handling
the subject entity’s products that would enhance profit margins. Similar to the other example,
market participants’ perceptions of how prerogatives of control translate into value influence the
investment decision.
In each case, the task of the valuation specialist is to identify and evaluate the feasibility of the
available strategies from the perspective of market participants for the subject interest. The
appropriate MPAP considers not only the magnitude of the available economic benefits, but also
the degree to which such potential benefits will influence the price paid by market participants
for the subject controlling interest in an orderly transaction at the measurement date. The
Working Group is not stating that the economic benefits must be precisely quantified in each
case. Rather, at a minimum, analysis should be performed to identify which form(s) of economic
benefit market participants would reasonably expect to enjoy and some general magnitude of the
effects of those benefits on value.
4 Whether such cost savings would contribute to the MPAP depends on how the above-market
compensation and other costs were treated in measuring the foundation value. There is diversity of
opinion in the profession as to situations where such “normalizing” adjustments are appropriate. The
resolution of that controversy is beyond the scope of this Valuation Advisory.
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Concluding Observations
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The Working Group believes that MPAPs should be supported by reference to either enhanced
cash flows or a lower required rate of return from the market participant perspective. The
referenced economic benefits should be sufficient to provide market participants with an
adequate return on the concluded fair value of the controlling interest. The Working Group
anticipates that in many instances such benefits will not be reliably identifiable, resulting in
either no, or a small, premium.
Notwithstanding the emphasis on cash flow and risk differentials in supporting MPAPs in fair
value measurement, the Working Group acknowledges the merit of analyzing historical data
regarding observed premiums from closed transactions. Such data might provide some examples
of the extent to which buyers have expected improvement in cash flows or reduction of risk in
specific transactions. However, to conform to best practices, valuation specialists should
critically evaluate the quality and relevance of such benchmark premium data to assess its
applicability to the valuation subject. It is inconsistent with best practices to rely solely on
benchmark premium data to evaluate the reasonableness of the MPAP in a fair value
measurement.
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CONCEPTUAL CONSIDERATIONS
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The Working Group believes that a persuasive fair value measurement for a controlling interest
in a business enterprise should be supported by a clear explanation of the incremental economic
benefits available to market participants. In this section of the VFR Advisory, we discuss the
prerogatives of control that are the means for generating economic benefits and provide examples
of the economic benefits typically associated with changing control of a business enterprise. This
Advisory also discusses the characteristics of a business enterprise that are likely to influence the
magnitude of the economic benefits available to market participants.
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Prerogatives of Control
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The prerogatives of control refer to the rights possessed by the owner of a controlling interest in a
business enterprise to direct the management and policies of a business enterprise. Following is a
nonexhaustive list of the specific means by which such control is exercised:5
Liquidating, dissolving, selling, or recapitalizing the company
Selling or acquiring treasury shares
1. Appointing or changing operational management
2.
Electing members of the board of directors
3. Determining management compensation and perquisites
4.
Setting operational and strategic policy for the business
5. Acquiring, leasing, or liquidating business assets
6.
Selecting suppliers, vendors, and subcontractors
7. Negotiating and consummating mergers and acquisitions
8.
9.
10. Registering the company’s equity securities for an initial or secondary public offering
11. Registering the company’s debt securities for public offering
12. Declaring and paying dividends
13. Changing the capital structure
14. Changing the articles of incorporation or bylaws
15. Selecting joint venture and other business partners
16. Making product and service offering decisions
17. Making marketing and pricing decisions
18. Entering into licensing and other agreements regarding intellectual property
19. Blocking any or all of the above actions
5 These items are based on lists appearing in Business Valuation Discounts and Premiums; by Shannon P.
Pratt, John Wiley & Sons, Inc., Second Edition, 2009, pages 17-18 and in Valuing a Business: The Analysis
and Appraisal of Closely Held Companies; by Shannon P. Pratt and Alina V. Niculita, The McGraw-Hill
Companies, Inc., Fifth Edition, 2008, page 385.
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The Working Group believes that the prerogatives of control noted above have limited inherent
value, but are rather the means through which market participants implement strategies designed
to generate economic benefits. For example, the bare ability to select a company’s suppliers
conveys no particular economic benefit to market participants, and therefore does not influence
the fair value of a controlling interest. However, if selecting suppliers with whom market
participants have existing relationships allows market participants to achieve a lower cost of
sales, that economic benefit will potentially influence the MPAP.
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Economic Benefits that Support MPAP
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The Working Group believes that the economic benefits that support MPAPs ultimately manifest
in two ways: (1) enhanced cash flows; or (2) lower required rates of return. The task of the
valuation specialist is to identify the economic benefits available to multiple market participants
and support a magnitude of the amount by which such benefits may reasonably be expected to
increase the price paid by market participants for the subject interest over its Foundation value.
The Working Group notes that the economic benefits (for example, synergies) discussed herein
refer to those available to a group of market participants; those available only to a single market
participant generally would be excluded.6
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Enhanced Cash Flows
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Market participants contemplating purchase of a controlling interest in a business enterprise often
anticipate implementing business strategies that are not currently being implemented, or are not
available to be implemented, by the current owners. These strategies may increase cash flows or
improve investment returns through other strategy revisions. As stated previously, this Advisory
will refer to the concept of cash flow improvement to denote all forms of value-enhancing
investment and operational strategies. In all cases, an acquisition premium would only be
supported by changes believed to enhance the total return on investment. Potential improvements
may include the following areas, which are illustrative and not intended to be an all-inclusive list:
• Superior revenue growth. Market participants may have greater financial capacity and/or
willingness to invest more in positive net present value projects in order to fuel future
revenue growth than the incumbent ownership group. Alternatively, market participants may
have complementary products or services that are expected to increase sales of the subject
entity, the market participants, or both. Market participants may anticipate enhanced pricing
power following the acquisition of a competitor. They may have existing relationships with
customers that have previously been inaccessible to the subject entity. In addition, market
participants may have existing distribution networks that are broader than those of the subject
entity that could contribute to superior revenue growth.
6 Market participant synergies should be viewed in terms of the overall level of value enhancement
achievable by multiple market participants rather than simply matching the nature of specific benefits.
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•
Increased operating margins. Market participants may anticipate increasing operating
margins by eliminating redundant operating costs or achieving economies of scale through
the addition of incremental sales volume. Larger companies are often able to negotiate
superior terms with suppliers, resulting in lower cost of sales. For privately held companies,
the normalization of
market participants might expect
compensation and contract amounts that had not been at market-based rates.7
increased margins
through
• Working capital efficiencies. Relative to the subject entity under current stewardship, market
participants may expect to maintain lower cash balances, negotiate more favorable payment
terms or inventory delivery schedules with suppliers, or have tighter credit policies.
• Capital expenditure efficiencies. Market participants may have more favorable ongoing
access to necessary capital equipment, or they may be able to consolidate production and
distribution capacity.
Regardless of the source, to be relevant in differentiating the fair value of a controlling interest,
the enhanced cash flows must be incremental to those expected by the subject entity under
current stewardship. In other words, enhanced cash flows giving rise to an MPAP are
incremental to prospective financial information that reflects the ongoing operations of the
business enterprise absent a change of control transaction.
We recognize that a fundamental aspect of understanding value of an entity is the prospective
financial information that management provides. The Working Group believes that forecasts
provided by management, unless they reflect information unknown to the market, have in most
circumstances been priced into and are represented by the publicly traded price. Indications of
value beyond the publicly traded price would need to reflect enhancements to cash flow or
reduction of risk that could be effectuated by an acquirer of the entity as discussed throughout
this Advisory.
Furthermore, implementation of strategies expected to generate cash flow benefits may require
the acquirer to incur significant costs. For anticipated revenue synergies, such costs may include
investments in incremental production capacity and/or distribution infrastructure. Anticipated
cost savings may be realized only after severance costs have been incurred. In all cases, the
anticipated cash flow benefits that contribute to MPAP should be assessed in combination with
required costs to implement the corresponding strategy.
The Working Group notes that there may be incremental risks to achieving forecast cash flow
enhancements and that such incremental risks may be considered in the valuation either by
adjusting the enhancements to cash flow or by adjusting the required rate of return, and any such
adjustments would need to be sufficiently supported.
7 Whether such cost savings would contribute to the MPAP depends on how the above-market
compensation and other costs were treated in measuring the foundation value. There is diversity of
opinion in the profession as to where such “normalizing” adjustments are appropriate. The resolution of
that controversy is beyond the scope of this Valuation Advisory.
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The effect of cash flow enhancements will influence the magnitude of the MPAP only to the
extent that market participants are willing to credit the subject entity with the economic benefits
resulting from them.
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Lower Required Rate of Return
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When evaluating the purchase of a controlling interest in a business enterprise, market
participants may have a lower required rate of return than investors contemplating the purchase
of an otherwise comparable noncontrolling interest in the entity under current stewardship. There
are several reasons market participants may have a lower required rate of return for a controlling
interest, including:
• Optimized capital structure. If the subject entity employs a suboptimal mix of debt and
equity financing, the weighted average cost of capital may be reduced by adjusting the
subject entity’s capital structure. While it may be more common for companies to use a less-
than-optimal amount of debt financing, the costs of financial distress may also cause an over-
leveraged company to have an unfavorable cost of capital. Judgments as to the optimal
capital structure for the subject entity may be made with reference to the observed capital
structures of companies in the subject entity’s industry.
• Company size benefits. Most valuation specialists agree that, all else being equal, larger
companies enjoy lower costs of capital than smaller companies for reasons such as greater
diversification, and increased purchasing and pricing leverage, among others. Often, market
participants are larger than the subject entity and therefore have a lower cost of capital.
• Reduced operating risk. Market participants may perceive opportunities to reduce the
operating risk of the business through strategies designed to reduce the volatility of raw
material pricing, adopting a more variable cost structure, mitigating customer concentrations,
or securing more long-term customer contracts, among others. Such measures may reduce the
operating risk and cost of capital for the business enterprise.
Such effects will influence the magnitude of the MPAP only to the extent that market participants
are willing to credit the subject entity with the economic benefits resulting from a lower cost of
capital.
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There is no consensus among valuation specialists regarding the relationship between the size of
the target and the required return from a market participant perspective. Some valuation
specialists observe that market participants use a cost of capital commensurate with the size of
the target when estimating the price to be paid in arm’s length transactions. Others observe that
the market participants, when making investment decisions, use instead a cost of capital
reflecting the benefits of the increased size and diversification of the combined entity post-
transaction. On the basis of its outreach efforts, the Working Group has concluded that both
perspectives (cost of capital based on the size of the target and cost of capital based on the size of
the combined entity post-transaction) are relevant when measuring fair value. When the
resulting range of value indications is wide, the importance of the valuation specialist’s judgment
in selecting the point most reflective of fair value increases.
• The valuation specialist may seek to supplement this judgment with reference to the results
of other valuation methods under the market or cost (asset-based) approaches. When this is
done, the point in a range where there seems to be the most consensus across approaches
could provide relevant insights implying which is the stronger size premium case.
• The valuation specialist may be able to use the rate of return implied in a past business
combination of the subject entity to inform its risk assessment in a current fair value
measurement.8
• The valuation specialist may be able to reference implied rates of return for similar acquired
assets or companies.
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Other Key Points
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The Working Group cautions that it may not be appropriate to assume that market participants
will always incorporate all economic benefits of control into the price paid for a controlling
interest in a subject business, even if such benefits exist. In other words, market participants
ordinarily do not give away all of their upside—the incremental economic benefits—that may
arise from a transaction. How much of the upside is included in the transaction price depends, in
part, on the competitive dynamics of the sale process.
8 Any analysis of rates of return implied by past business combinations should exclude the effect of buyer-
specific synergies in the cash flows.
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Furthermore, the Working Group believes that it is incorrect to assume that the public market has
“underpriced” noncontrolling interests in the subject entity in measuring the magnitude of an
MPAP for a controlling interest. For example, stock analysts frequently publish price targets for
the shares of publicly traded companies. The existence of price targets in excess of the prevailing
stock price does not provide direct evidence of the MPAP. In such cases, the valuation specialist
should investigate the investment thesis underlying the price target. If the price target is premised
on the expectation that the company may soon be “in play” for a change of control transaction or
an expectation that a controlling interest buyer would implement strategies to increase the
economic benefits generated by the firm, such price targets may provide indirect support for an
MPAP. However, in most cases, the Working Group believes that analysts’ price targets do not
reflect factors that are relevant to MPAP considerations.
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BUSINESS CHARACTERISTICS INFLUENCING MARKET PARTICIPANT
ACQUISITION PREMIUM
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As valuation specialists evaluate the potential economic benefits that may be derived by market
participants from exercising the prerogatives of control in a manner different from current
ownership, it is important to assess the reasonableness of the assumed economic benefits in the
context of the characteristics of the subject business enterprise and the industry in which it
operates. The following discussion is not intended to be comprehensive, but is representative of
the factors that valuation specialists should consider in estimating the price market participants
would pay for the subject controlling interest. The discussion is principles-based but the Working
Group acknowledges there may be exceptions based on the facts and circumstances of individual
cases.
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Acquisition Activity in the Industry
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The number of change of control transactions in a given industry fluctuates over time. When the
frequency of transactions in an industry increases, it may signal that market participants perceive
greater opportunities to generate economic benefits by exercising the prerogatives of control. For
example, regulatory or other changes may favor a smaller number of larger industry players,
prompting a round of consolidation. Alternatively, acquisition activity may increase because
economic turmoil is causing the financially weaker members of the industry to seek to be
acquired by more stable and less financially distressed companies.
Robust acquisition activity in the industry may increase the number of market participants that
would contemplate acquiring a controlling interest in the subject entity. As a result, the selling
shareholders may be able to realize greater economic benefits due to the increased number of
bidding market participants, thereby increasing the MPAP.
In contrast, as a consolidation trend for an industry is confirmed by an increasing number of
announced transactions, the fair value of noncontrolling interests in the subject entity may
increase as investors come to expect that a change of control transaction on favorable terms is
imminent. In such cases, the MPAP may be reduced as the difference between the fair value of
controlling and noncontrolling interests is compressed.
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Stage in Company Life Cycle
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Growth-stage target companies generally offer greater opportunities for realizing economic
benefits than more mature companies. For example, market participants may be able to leverage
existing distribution networks that growth-stage companies have not yet had the opportunity or
financial resources to develop, providing opportunities for superior revenue growth and/or
enhanced operating margins. Mature target companies, on the other hand, are likely to present
fewer opportunities for enhanced cash flows or lower cost of capital. As a result, the appropriate
MPAP may be lower for such companies.
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Market Participant Attributes
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Market participants are commonly classified into three general categories:
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• Strategic acquirers already operate in the same business as the subject entity. Revenue
synergies and cost savings tend to be the most important economic benefits available to
strategic acquirers exercising the prerogatives of control. Strategic acquirers may be
competitors of, suppliers to, or customers of the subject entity.
• Financial acquirers do not have any existing complementary business operations. Financial
acquirers, such as private equity funds, are less likely to identify significant revenue
synergies or operating cost savings than strategic acquirers. Financial acquirers may possess
financing advantages relative to strategic acquirers.
• Conglomerate acquirers are operating companies that acquire the subject entity to increase
the diversification of the acquirer’s existing revenues and cash flows. While there may be
some administrative efficiencies that are expected to contribute to enhanced cash flows, the
expectation of diversification benefits, and thus lower risk, causes the benefits available to
conglomerate acquirers to more closely resemble financial rather than strategic acquirers.
While this classification is helpful for evaluating the attributes of market participants and the
nature and magnitude of economic benefits they will expect from owning control of the subject
entity, the Working Group emphasizes that the boundaries between the categories are permeable.
For example:
• Financial acquirers often acquire controlling interests in companies to “bolt on” to existing
portfolio investments, thereby resembling strategic acquirers in many respects.
• Financial acquirers may anticipate significant cash flow enhancements from replacing what
they perceive to be an underperforming management team, or from the eventual sale to a
strategic acquirer, or through taking the entity public with favorable initial public offering
pricing.
• Strategic or conglomerate acquirers may have access to financing arrangements on terms at
least as favorable as financial acquirers.
• A decision to operate as a private company avoids the costs of public company compliance.
Valuation specialists should identify market participants’ attributes and relate the expected
economic benefits of control to the likely strategies of such acquirers. In many cases, strategic,
financial, and conglomerate acquirers compete with one another for the same targets and the fair
value of controlling interests could appear to encompass a mix of strategic and financial benefits.
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Size of Market Participants Relative to Subject Entity
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Market participants are often larger than the subject entity. This is unsurprising, as larger
companies may be positioned to realize economic benefits that are not available to a smaller
company on a stand-alone basis. For example, other factors being equal, larger companies are
more likely to have favorable access to capital, existing distribution infrastructure and
administrative capacity, and superior negotiating leverage with suppliers and customers. As a
result, the larger market participants may be able to extract greater economic benefit from the
subject entity than the current owner(s)—and in a shorter period of time. As a result, the MPAP
may be positively related to the size of the market participants for the subject controlling interest.
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Balance of Information
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Market participants forecast the economic benefits to be realized from an acquisition on the basis
of information discovered during due diligence procedures. Assuming the subject entity is a
willing party to the selling process, the due diligence associated with acquisition of a controlling
interest is likely to yield information not available to investors in noncontrolling interests in the
subject entity. The Working Group has identified three varieties of information asymmetry that
can influence the fair value of a controlling interest, and by extension, the MPAP, in certain
circumstances:9
1. Information available to market participants for controlling interests, but not market
participants for noncontrolling interests. In general, the subject entity’s Equity
Foundation reflects only publicly available information regarding the subject entity.
However, at the measurement date, there may be relevant information regarding the
results of operations or other factors that are disclosed to market participants for
controlling interests but not yet publicly disseminated. For example, if the measurement
date coincides with the end of the subject entity’s reporting period, operating results for
the period are likely known by the company with a considerable degree of certainty
although the company may have issued only limited guidance to analysts and investors so
that the publicly traded share price does not reflect the information. The existence of
nonpublic information favorable to the subject entity may support a larger MPAP; if the
nonpublic information is unfavorable, that may indicate a lower MPAP.
9 This discussion is in the context of publicly traded entities. For private companies, the Foundation value is
not observable and so the application of information asymmetry is more difficult to measure as it relates
to Foundation value.
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2. Information known to the subject entity but not market participants. If the information is
favorable to the subject entity, it is likely to be disclosed to the market participants during
due diligence. Under the definition of fair value, market participants are assumed to be
“knowledgeable, have a reasonable understanding about the asset or liability and the
transaction based on all available information, including information that might be
obtained through due diligence efforts that are usual and customary.”10 As a result, even if
the subject entity would prefer that market participants not be aware of unfavorable
information, such information is assumed to be known in measuring fair value, resulting
in a comparatively lower MPAP. The Working Group believes favorable information
revealed to the market participants but not reflected in the Equity Foundation would
increase the MPAP.
3. Information known only to a single market participant, but not the subject entity. A
particular market participant might have information that enables them to take advantage
of unique revenue synergies or cost savings. If this information is truly known only to a
single market participant, the effect on the fair value of the subject controlling interest is
likely to be modest as the market participant would be unwilling to pay more than the
value of the economic benefits available to the next most advantageously positioned
market participant. In other words, if such information is known only to a specific buyer,
the financial value impact resulting from this information should be excluded from the
estimation of fair value.11
In considering information asymmetries, the valuation specialist should be careful to not double
count the impact of such items. The impact of some information asymmetries might already be
reflected in the typical inputs (i.e., cash flows and/or required rates of return).
The Working Group cautions that it can be difficult to support the existence and magnitude of
most information asymmetries. Further, the degree to which the balance of information
contributed to historically observed transaction premiums will, in most cases, be impossible to
discern.
10 ASC 820-10-20.
11 The working group recognizes there may be instances in which different market participants have
access to different information that could result in similar financial value impact. These would be
considered market participant synergies because in a competitive bidding situation they would likely be
paid for.
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Capital Structure of Subject Entity
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Among the prerogatives of control is the ability to adjust the subject entity’s capital structure. As
discussed previously, shifting to a more optimal capital structure is one strategy for reducing the
weighted average cost of capital. The farther the subject entity’s capital structure is from the
optimal financing mix, the greater the potential MPAP. The Working Group notes that in the
application of invested capital market multiples, some aspect of this benefit may be already
factored in because guideline companies typically have a more optimal capital structure.
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Management Objectives
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Privately held companies often are managed with objectives that differ from those of publicly
traded companies. This difference is not necessarily a matter of “quality” of management
(addressed in the next section), but instead might be a matter of differing goals. Such differences
might include above-market compensation paid to the private company owner, lease rates that do
not reflect market conditions, avoidance of the use of debt financing, net working capital at levels
above industry norms, and other similar factors.
Depending on how these factors are addressed in determining the Foundation value, the MPAP
for such a privately held company might exceed that measured for many publicly traded entities.
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Quality of Management
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Another prerogative of control is the ability to change the subject entity’s management team. If
the quality of the incumbent management team is perceived by market participants to be less
than optimal, it may be more likely that strategies to enhance cash flows or reduce the cost of
capital can be successfully implemented. Such strategies might contribute to a larger MPAP.
Conversely, if market participants consider the existing management team to be of high quality,
opportunities to realize further economic benefits are likely to be limited, resulting in a smaller
MPAP.
While the notion of management quality is inherently subjective, objective metrics can provide
insight regarding the effect of current management policies. Metrics such as growth, profitability,
asset utilization, and cost of capital can be benchmarked against peer companies to provide
insight regarding the quality of incumbent management. However, such measures must be
interpreted in the context of the management team’s tenure and firm-specific factors, such as
contracts, facilities, and other assets that were inherited from prior management teams.
The Working Group observes that poor quality management is unlikely to be a factor cited in
support of an MPAP since it rarely will be acknowledged by the management team responsible
for the fair value measurement. Nonetheless, it is an important consideration and highlights the
importance of comparative financial analysis when evaluating the economic benefits that may be
available to market participants exercising control over a business enterprise.
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Regulatory Factors
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Regulatory factors can be significant considerations in business combinations. In addition,
regulatory factors can mitigate or amplify the degree of control exercised by a particular
ownership interest. Purchase prices and acquisition premiums in transactions outside the United
States can differ significantly from those inside the United States because of different regulatory
environments.
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There are a variety of regulatory factors that may be relevant to the analysis of the MPAP:
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• Regulations governing merger and acquisition activity. Some regulations, such as antitrust
provisions designed to limit the potential for monopoly power, may directly affect which
market participants are potential acquirers of the subject entity. Regulatory provisions that
significantly reduce the number of potential bidders for the subject entity may have a
dampening effect on the MPAP.
• Limitations on foreign direct investment. As with anti-trust provisions, those aimed at
limiting the ability of foreign market participants to acquire a controlling interest in the
subject entity may reduce the MPAP applicable to the subject entity.
•
•
Investor protection measures. Investor protection measures such as uniform accounting
standards and corporate securities laws are generally designed to protect noncontrolling
investors. Some measures may even grant noncontrolling shareholders in a business
enterprise the right to block the controlling owner’s ability to unilaterally exercise certain
prerogatives of control. Since the MPAP measures the difference between the fair value of
controlling and noncontrolling interests, regulations that increase the fair value of
noncontrolling interests will, all else being equal, reduce the MPAP.
Industry-specific regulations. Some industries, such as banking and telecommunications, are
governed by a host of industry-specific regulations that govern the conduct of, and
competition among, firms within the industry. Such industry regulations can shift with
economic conditions and the political environment. Industry-specific regulations that are
perceived to promote consolidation activity may increase the MPAP. If, instead, the
prevailing regulatory stance is one of limiting acquisition activity, the MPAP may be lower.
The influence of regulatory factors should be evaluated relative to observed transaction activity
in the subject entity’s industry.
504
Corporate Bylaws and Governing Documents
505
506
507
Valuation specialists should consult the subject entity’s corporate bylaws and other governing
documents to determine whether there are any provisions that may restrict the ability of the
subject interest to exercise control over the business enterprise.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
24
508
509
510
511
512
513
514
515
516
517
518
The Working Group believes it is a mistake to conceive of control as being absolute; rather,
control of the enterprise should be evaluated along a continuum extending from substantial
minority investments to complete ownership of all equity share classes. For example, the subject
entity’s governing documents may grant preferred shareholders the right to vote as a class on
certain corporate actions, or to elect a certain number of corporate directors. In other cases, a
supermajority vote of the common shares may be required to approve a sale of the business.
Some companies issue both voting and nonvoting shares with the economic rights of the
nonvoting shares being identical to the voting shares. Observed differences between trading
prices for noncontrolling interests in the two share classes are typically very small. Because this
is based on a comparison of the prices of noncontrolling interests, such data is of little use in the
analysis of MPAP.
519
Transaction Structure
520
521
522
523
524
525
526
527
528
529
530
The structure of a transaction can exert a significant influence on the nominal price paid for a
controlling interest. The tax characteristics of a transaction, including the availability of
amortization benefits to the market participants, can affect the purchase price. ASC 350 requires
consideration of whether fair value reflects a taxable or nontaxable transaction structure.
Controlling interest acquisitions often include contingent consideration arrangements. Depending
on how the contingent consideration is measured, the nominal purchase price may be overstated
or understated.12
Valuation specialists should carefully consider the influence of transaction structure on both
observed transaction multiples and control premiums, as well as fair value measurement of the
subject controlling interest. Unfortunately, important details that would permit careful analysis of
closed transactions are usually unavailable to the valuation specialist.
531
Summary
532
533
534
535
536
537
538
539
540
In summary, the Working Group believes this section illustrates many of the factors that
valuation specialists would consider in estimating the price market participants are willing to pay
for the subject controlling interest. The preceding listing and discussion of business
characteristics and considerations is not intended to capture all factors that may influence an
MPAP. Instead, the Working Group focused on topics that, based on its collective professional
experiences, are encountered most often in practice. Consideration of these concepts may be
helpful when performing original analysis to develop an MPAP. These concepts may also be
useful in assessing the reasonableness of another party’s MPAP analysis, such as in a peer or
specialist review context.
12 The Working Group notes that contingent consideration arrangements are less common in acquisitions
of public companies (the basis for observed transaction premiums).
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
25
541
Conclusions
542
543
544
545
546
547
548
549
A well-supported fair value measurement for a controlling interest in a business enterprise should
include consideration, from the market participants’ perspective, of the incremental economic
benefits of control. The prerogatives of control may lead to economic benefits in many areas and
the valuation specialist should review the typical business characteristics likely to influence the
magnitude of the benefits available to market participants.
The Working Group believes that use of the framework discussed will provide an important
context for review of the valuation results, and will increase the relevance and reliability of the
associated fair value measurement.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
26
ANALYTICAL METHODS
550
551
552
The remaining sections of this VFR Advisory address some of the important analytical methods
involved in expressing MPAPs, analyzing observed premiums from historical transactions, and
assessing the reasonableness of the concluded MPAP.
553
Expressing the Market Participant Acquisition Premium
554
555
556
557
558
559
560
561
562
563
564
565
566
567
568
569
570
571
572
573
Although the MPAP may be expressed as a dollar amount (the difference between the pro rata
fair value of a controlling interest and its Foundation), valuation specialists customarily express
valuation premiums and discounts as the percentage difference. This is intuitive and facilitates
the comparison of premiums across companies of different sizes.
Valuation specialists have traditionally used the Equity Foundation to calculate the transaction
premium as a percentage. This is consistent with the methodology for reporting premiums used
by FactSet Mergerstat®, LLC, which the Working Group observes (based on its experience) to be
the most widely cited source of historical control premium data. It is also consistent with the way
in which premiums are commonly reported in the financial press.
In deliberating the MPAP, the Working Group concluded that the traditional method of
calculating transaction premiums is potentially misleading. Specifically, the economic benefits
realized through exercising the prerogatives of control enhance the fair value of the enterprise as
a whole, not just the fair value of the equity.13
Further, expressing the MPAP as a percentage of the Equity Foundation distorts the
comparability of the MPAP among companies with different capital structures. For example,
assume Foundation TIC value for both Company A and Company B is $100 million. Company A
has $10 million of interest-bearing debt outstanding and Company B has $50 million of interest-
bearing debt outstanding. Assume further that, from the perspective of market participants, the
magnitude of economic benefits from exercising the prerogatives of control for Company A is
identical to that for Company B, such that the MPAP applicable to each company is $20 million.
13 When there is a change of control transaction, the debt typically is due at its face amount, which
approximates or equals fair value.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
27
574
575
576
577
As shown in the following table, the traditional method of expressing the premium as a
percentage of the Equity Foundation will cause the MPAP for Company A to appear smaller than
that of Company B. However, when expressed as a percentage of the TIC Foundation, the
MPAPs—which are economically equivalent (the same dollar amount)—are identical.
F air Value of Interes t-B earing Debt
F air Value of E quity
F air Value of Total Inves ted Catpial
(Mark etable, Noncontrolling Interest Basis)
Company A Company B
$10.0
90.0
$100.0
$50.0
50.0
$100.0
F air Value of Total Inves ted Capital
(Controlling Interest Basis)
$120.0
$120.0
Market P articipant Acquis ition P remium
$20.0
$20.0
Traditional Method
Market P articipant Acquis ition P remium
F air Value of E quity
(Mark etable, Noncontrolling Interest Basis)
$20.0
$90.0
$20.0
$50.0
Market P articipant Acquis ition P remium (% )
22.2%
40.0%
Total Invested Capital Method
Market P articipant Acquis ition P remium
F air Value of Total Inves ted Capital
(Mark etable, Noncontrolling Interest Basis)
$20.0
$100.0
$20.0
$100.0
Market P articipant Acquis ition P remium (% )
20.0%
20.0%
578
579
580
581
582
583
584
585
586
The Working Group believes that best practices include expressing as well as applying the
MPAP in the context of a TIC Foundation.14 The Working Group acknowledges that following
this best practice will require the restatement of observed transaction premiums that have been
traditionally expressed based on an Equity Foundation. Nonetheless, the Working Group believes
that the benefits of doing so (alignment with the underlying economic benefits giving rise to the
MPAP and greater comparability across firms with different capital structures) outweigh the
incremental effort. Since the observed transaction premiums relate to publicly traded companies,
the information is ordinarily available to enable expression of the observed transaction premiums
using a TIC Foundation.
14 Concepts of TIC level premiums may not be applicable for certain industries (e.g., certain types of
financial services entities).
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
28
587
Analyzing Historical Premium and Transaction Data
588
589
590
591
592
593
594
595
596
597
598
599
600
601
602
603
604
605
606
607
608
609
610
Transactions in which the buyer acquires a controlling interest in a publicly traded company
afford opportunities to observe the magnitude of transaction premiums paid by acquirers.
Valuation specialists often reference observed premiums when estimating or supporting the
MPAP for the subject entity. Although similar transaction premiums presumably also exist in the
acquisition of private companies, the absence of an observable Foundation price for the acquired
company precludes calculating reliable premiums. However, such transactions may yield reliable
multiples of revenue, earnings measures, or other relevant metrics that are indicative of the fair
value of a controlling interest.
The Working Group cautions that exclusive reliance on observed transaction premium data
provides, in most cases, insufficient support for a concluded MPAP. Nonetheless, observed
transaction premium data may be valuable. The Working Group believes that observed historical
premiums provide potentially relevant (albeit indirect) evidence of the appropriate magnitude of
the incremental economic benefits anticipated by market participants. The observed premiums
can be used to corroborate (or question) the reasonableness of the cash flow forecasts and
discount rates underlying fair value measurements within the income approach. However,
exclusive reliance on observed transaction premiums without careful analysis of the subject
entity’s relative financial performance, valuation multiples, and other metrics can result in an
unreliable fair value measurement.
The valuation specialist may consider the qualitative factors discussed in the earlier section—
Business Characteristics Influencing Market Participant Acquisition Premium—to narrow the
range of observed premiums from the transaction data that may be applicable for the subject
entity. Analysis of these factors may also support the incremental benefits assumed in a
quantitative analysis of the MPAP.
611
Assessing the Underlying Data Set – Transaction Data
612
613
614
615
616
617
618
619
620
621
Valuation specialists should carefully analyze available transaction data and consider various
factors specific to the acquired company, the seller, the acquirer, or the transaction that may
warrant adjustments to the data. Factors valuation specialists should consider include the
following:
• Size of Interest Transacted. The valuation specialists should attempt to ascertain whether the
interest transacted represents 100 percent ownership of the company. As discussed
previously, there is a continuum of control, and ownership interests of less than 100 percent
may not be able to unilaterally exercise the prerogatives of control.
• Financial Condition of Seller. Transactions involving sellers motivated by financial distress
or bankruptcy usually do not provide reliable evidence for fair value measurement.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
29
622
623
624
625
626
627
628
629
630
631
632
633
634
635
636
637
638
639
640
641
642
643
644
645
646
647
648
649
650
651
652
653
654
655
• Relationship of Buyer and Seller. If the parties to the transaction have some pre-existing
relationship, it may indicate that the transaction terms do not reflect arm’s-length negotiation,
which would limit the usefulness of the transaction data when measuring fair value.
• Stated Rationale for Transaction. When available, analysts should review press releases and
other corporate announcements describing the transaction to determine if the price paid (and
therefore the multiples and premiums observed) reflected any buyer-specific synergies or
other characteristics that render the transaction data unsuitable for use in a fair value
measurement.
• Changes in Market Conditions. Unlike guideline public company data, guideline transaction
data rarely lines up with the measurement date. Rather, some amount of time will have
elapsed between the occurrence of the observed transaction and the measurement date.
Depending on the length of the time gap, analysis of changes in market, economic or industry
conditions (as reflected in pertinent market indices or economic series) between the two dates
may be appropriate to assess the relevance of the observed transaction data to the fair value
measurement.
• Stock Price and Volume Fluctuations Prior to Announcement. In some cases, the stock of the
target company may exhibit unusual volatility and/or increased trading volume prior to the
formal announcement of the transaction. The existence of such phenomena may indicate that
the implied acquisition premium should be calculated with reference to an earlier, unaffected,
stock price.
• Transaction Structure. Especially for transactions involving private companies, an array of
transaction structure concerns can distort the reported data. For example:
o Acquirers may purchase either the stock or the assets of the target company.
o Certain corporate assets such as cash or real estate may not be included in the transaction.
o The consideration may include a note bearing interest at a rate other than market.
o The fair value of contingent consideration arrangements is often difficult to measure at
the transaction date (and may be excluded altogether from a reported price).
• Transaction Process. The valuation analyst should endeavor to ascertain whether the
transaction was the culmination of a deliberate selling and marketing effort administered by
competent investment bankers, a hostile takeover, a bidding war, or negotiation with a single
acquirer.
• Transaction Status. Referenced transactions may have been announced, but not yet closed at
the measurement date. In such cases, valuation specialists should carefully consider how
much weight to give to such transactions.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
30
656
657
658
659
660
Given the limited availability of data regarding most change of control transactions, it is unlikely
that valuation specialists will be able to obtain a comprehensive understanding of the factors
described above for each transaction relied on. Nonetheless, by considering these factors,
valuation specialists might be able to exclude transaction data that is misleading for the subject
fair value measurement.
661
Other Considerations – Historical Premium Data
662
663
664
665
666
667
668
669
670
671
672
673
674
675
676
677
678
679
680
681
682
683
684
685
686
687
688
689
690
691
692
Available data regarding observed premiums in historical transactions present additional
challenges for valuation specialists.
In many cases, there will be a trade-off between the quantity of available premium data and the
quality of the data (in other words, the data’s relevance to the fair value measurement). Valuation
specialists should evaluate the relevance of referenced premium data by considering the degree to
which the target company is comparable to the subject entity, and whether the acquirer is
representative of market participants for the subject entity at the measurement date.
The number of referenced transactions can be increased by considering those occurring during a
longer period of time preceding the measurement date. However, transactions more proximate to
the measurement date are generally preferable, especially when consolidation trends within the
subject entity’s industry have evolved. When evidence from transactions near the measurement
date is limited or not available, valuation specialists may wish to consider industry premiums
over a longer period, such as one, three, or five years prior to the measurement date. However,
when doing so, valuation specialists should be careful to consider what effect, if any, changes in
economic, market, or industry factors may have had on the level of observed premiums over the
period analyzed.
The reported magnitude of the observed premium from a transaction is affected by the date
selected to serve as the basis for expressing the premium (the date of the Foundation price).
Valuation specialists should review the target company’s public share trading volume and price
fluctuations for the weeks leading up to the transaction announcement date to identify any
unusual or unexplained market activity. For example, if the target company had retained a
financial advisor to explore strategic alternatives, or negotiations with potential acquirers are
known to the public, it is preferable to calculate the transaction premium using a price from a
date before such information began to be incorporated into the target company’s publicly traded
stock price.
Valuation specialists routinely consider premiums implied by the difference in the transaction
price (on the announcement date) to the traded price from one to 30 days prior to the
announcement of the transaction. Valuation specialists may also calculate transaction premiums
based on the average stock price over a period. The Working Group believes that, if applied
consistently, such techniques can be used to improve the relevance and reliability of historical
premium data.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
31
693
Limitations Inherent in Observed Premium and Transaction Data
694
695
696
697
698
699
700
701
702
703
704
705
706
707
708
709
710
711
712
713
714
715
716
717
718
719
720
721
722
723
724
725
As noted in the previous sections of this VFR Advisory, valuation specialists considering
observed premium and transaction data must be vigilant to ensure that the data has been
evaluated for comparability and relevance to the subject entity.
Beyond these issues, valuation specialists should be aware of more fundamental concerns that
may limit the usefulness of such data when measuring the fair value of a controlling interest,
such as:
• Selection bias. Acquisition premiums and other transaction data may be subject to selection
bias since the population of observed transactions is limited to those companies that have
been acquired. Some valuation specialists emphasize that such companies typically represent
only a small portion of the universe of companies available to be acquired. While not subject
to empirical verification, one potential conclusion from this observation is that the control
value of the much larger population of companies not acquired is not greater than the
companies’ market capitalization because any incremental economic benefits would not be
sufficient to induce an acquirer to seek control.
In any case, since the premiums and transaction multiples applicable to the companies not
acquired cannot be observed, application of observed premiums or implied transaction
multiples to the subject entity may introduce an upward bias in the resulting fair value
measurement. Stated alternatively, transaction data may be drawn from a sample limited to
those companies for which the premiums would be highest. As a result, the valuation
specialist must carefully assess whether the subject entity is comparable to acquired
companies in the sample. The valuation specialist may consider the qualitative factors
discussed in the earlier section—Business Characteristics Influencing Market Participant
Acquisition Premium—to identify the most relevant observed premiums from the transaction
data that may be appropriate for the subject entity.
• Acquirer-specific synergies. Setting aside the potential for selection bias, data from closed
transactions may reflect acquirer-specific synergies that are not available to the relevant pool
of market participants. Specific synergies that are not available to market participants are
excluded from the definition of fair value. In most cases, the specific considerations
motivating the parties to the transaction cannot reliably be discerned from the available
transaction data. As a result, it is difficult for valuation specialists to precisely determine the
degree to which the observed premiums and transaction multiples are relevant when
measuring the fair value of the subject controlling interest.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
32
726
727
728
729
730
731
732
733
734
735
736
737
738
739
740
741
742
743
744
745
746
747
748
749
750
751
752
753
754
755
756
757
758
759
760
• Negative observed transaction premiums. Referenced sources of transaction premium data
often include negative premiums. Negative transaction premiums are observed when the
price per share paid for a controlling interest is less than the contemporaneous Foundation
price. The Working Group believes that negative observed transaction premiums should be
disregarded when measuring fair value. The Working Group believes that, absent anomalous
circumstances with respect to either the market for the subject entity’s shares or the
transaction process for the controlling interest (neither of which would be relevant in
measuring fair value), market participants would be unwilling to sell to a controlling interest
acquirer at a price less than the Foundation price.
Each of these concerns underscores the importance of careful analysis of the incremental
economic benefits available to market participants through exercising the prerogatives of control
in a manner different from the prior owners. The Working Group affirms the value of identifying
and referencing observed historical transaction premiums and other transaction data; however,
exclusive reliance on such data is not consistent with best practices for fair value measurement.
Assessing the Reasonableness of the Concluded Market Participant Acquisition
Premium
A credible fair value measurement should include an assessment of the overall reasonableness of
the measurement, including the MPAP applied or implied by the analysis. While premiums are
conventionally expressed as a percentage of the Equity Foundation, or in some cases the TIC
Foundation, the Working Group believes that the overall reasonableness of the fair value
measurement should be assessed more broadly.
Defined as the difference between two measures of fair value (the controlling interest and
Foundation), the MPAP is—strictly speaking—a byproduct of the valuation process rather than
an exogenous input. While valuation specialists commonly estimate the MPAP as an input in
measuring the fair value of a controlling interest (when using the guideline public company
method, for example), the level of rigor of analysis would depend on the importance of the
MPAP to the fair value measurement.15 Valuation specialists may consider using the following
techniques to evaluate the reasonableness of the fair value measurement of a controlling interest
in a business enterprise:
• Relative value measures. When feasible, valuation specialists should calculate ratios of total
invested capital to relevant performance measures, such as revenue; Earnings Before Interest,
Taxes, Depreciation, and Amortization (EBITDA); or other industry-relevant metrics. When
an MPAP has been added to a Foundation value, comparison of the resulting relative value
measures to transaction multiples observed from the available transaction data might assist
the valuation specialist in confirming the reasonableness of the selected premium.
15 The Working Group believes that the discounted cash flow method (when using market participant cash
flows and discount rates) and the guideline transaction method yield controlling interest indications; in
such cases, application of a discrete market participant acquisition premium is inappropriate.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
33
761
762
763
764
765
766
767
768
769
770
771
772
773
774
775
776
777
778
779
780
781
782
783
784
785
786
787
788
789
790
791
792
793
794
• Prospective Return Analysis. The MPAP is a function of the incremental economic benefits
anticipated by market participants from exercising the prerogatives of control. If the
guideline public company approach is the primary method used in measuring fair value, the
valuation specialist might consider also using a discounted cash flow approach and
calculating the discount rate implied by the effective earnings multiple. Comparing the
implied discount rate to the weighted average cost of capital for market participants can help
confirm the reasonableness of the MPAP.
• Calibration to prior transactions in the subject entity. In some instances, transactions for debt
or equity interests in the subject entity will have occurred during a relevant period of time
leading up to the measurement date. Market transactions may include those involving the
subject controlling interest, a noncontrolling interest in the subject entity, or other debt or
equity securities of the subject entity. The valuation specialist should carefully assess whether
the market transactions were arm’s-length and orderly, and if so, calibrate the fair value
measurement to the terms of the market transaction, taking into account changes in the
market since the transaction and fundamental differences between the subject controlling
interest and the interest transacted.
• Comparison to public market capitalization. When measuring the fair value of reporting units
of public companies, the Working Group believes that the concluded aggregate fair value of
the reporting units (on a controlling interest basis) should be compared to the market
capitalization of the company on the measurement date. The MPAP for the entire company
implied by such a comparison might be a barometer of the overall reasonableness of the fair
value measurement. However, there are cases in which there would reasonably be a
difference between the aggregate control value of the reporting units and the control value of
the total company, such as a conglomerate for which the parts might be worth more or less
than the whole or a company whose shares are not actively traded.
Valuation specialists may consider myriad value
indications when several valuation
methodologies are available and relevant for consideration in appraising a single valuation
subject. ASC 350-20-35-22 states that “the market price of an individual equity security (and
thus the market capitalization of a reporting unit with publicly traded equity securities) may not
be representative of the fair value of the reporting unit as a whole.” ASC 350-20-35-23 further
states that “measuring the fair value of a collection of assets and liabilities that operate together
in a controlled entity is different from measuring the fair value of that entity’s individual equity
securities . . . [t]he quoted market price of an individual equity security, therefore, need not be
the sole measurement basis of the fair value of a reporting unit.”
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
34
795
796
797
798
799
800
801
802
803
804
805
806
807
808
809
810
811
812
813
814
815
816
817
818
819
820
821
822
823
824
825
826
However, when the fair value of reporting units are estimated for ASC 350 purposes, whether for
entities with one or several reporting units, the entity’s market capitalization has been commonly
referenced as indirect value evidence even in cases where the unit of account prescribed by ASC
350 (i.e., the reporting unit) may be different from the quoted unit of measurement (i.e., the
individual shares of the entity). In the case of multiple reporting units, additional adjustments
have been made to present the best apples-to-apples comparison. In other words, the strength of
quoted evidence was compelling enough to consider even with an understanding that the quoted
price was not necessarily directly linked to the valuation subject.
In 2008, during the economic crisis, the market for and fair value of many assets and companies
declined and the level of difficulty for measuring value increased. At the 2008 AICPA National
Conference on Current SEC and PCAOB Developments, the SEC Staff offered its view of how
market capitalization may be used when assessing goodwill impairment. In particular, the SEC
staff indicated that they would expect objective evidence to support the reasonableness of
implied transaction premiums, whether a quantitative or qualitative analysis (or both) was used.
The SEC staff also indicated that while judgment may result in a range of reasonably possible
premiums, they expect the rigor of documentation to increase as the magnitude of the premium
increases.16
Whereas the practice of referencing market capitalization was in place before the 2008 SEC
speech, the Working Group believes the SEC staff’s views increased the usage of the market
capitalization reconciliation and it became more prevalent in audits of such entities. Since that
time, the FASB issued FASB ASU 2011-08. In the Basis for Conclusions in that document, the
FASB noted that the use of the qualitative screen will result in companies applying judgment on
when and how to perform the market capitalization reconciliation.17 Notwithstanding the
potential difficulty, the Working Group believes it is a best practice to perform an analysis of the
conclusion relative to the market capitalization.
In most cases, for publicly traded entities, it would be beneficial to perform a comparison of the
estimated fair values of the reporting units in aggregate with the entity’s market capitalization
and analyze the implied MPAP, if any. In such cases, the reasonableness of the implied MPAP
should be supported through quantitative and qualitative analyses. The rigor of the supporting
analyses and documentation will depend upon the magnitude of the implied control premiums,
particularly if the implied MPAP affects the conclusion regarding whether the reporting unit is
impaired.
16 Robert G. Fox III, “Speech by SEC Staff: Remarks before the 2008 AICPA National Conference on
Current SEC and PCAOB Developments,” December 8, 2008, transcript, https://www.sec.gov/
news/speech/2008/spch120808rgf.htm.
17 “BC34. The Board recognizes that many public entities reconcile the sum of the fair values of each
reporting unit to the entity’s market capitalization. The Board acknowledged that the amendments in
this Update may result in entities applying more judgment about when and how to perform this
evaluation; however, it concluded that this factor should not prohibit an entity from utilizing the
qualitative assessment.”
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
35
827
828
829
830
831
832
833
834
835
836
837
838
839
840
841
842
843
844
845
846
The majority of the implied premium will likely be supported through the enhancement in cash
flows or reduction in risk (or both), as discussed previously. The illustrative examples presented
in a subsequent section of this VFR Advisory provide a potential quantitative framework that
may be considered to support the implied premium. Additionally, the qualitative factors
discussed in the earlier section—Business Characteristics Influencing Market Participant
Acquisition Premium—may be considered to support the implied MPAP relative to the range of
observed premiums from the transaction data that may be applicable for the subject entity. In
certain situations, albeit rare, what appears to be an implied MPAP may result from transactions
in the company’s stock that are not orderly (e.g., a distressed sale).18 This would render the
comparison between the market capitalization and the estimated fair value to be not very
meaningful.
The Working Group believes that use of techniques like those described above is a vital part of
measuring the fair value of controlling interests in business enterprises. These tests of
reasonableness allow the valuation specialist to demonstrate to auditors, regulators, and other
interested parties that the MPAP is grounded in identifiable incremental economic benefits
available to the relevant pool of market participants, thereby increasing the relevance and
reliability of the associated fair value measurement.
This Advisory includes an illustrative example for analyzing MPAPs (see Selecting and
Assessing Market Participant Acquisition Premiums—Example; a subsequent section of this
paper located on page 42).
18 ASC 820-10-35-54D.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
36
THE FAIR VALUE CONTEXT
847
848
849
850
851
852
Valuation is context dependent. Valuation specialists refer to standards of value to define the
relevant context for valuation. The objective of this Working Group is to develop best practices
for the valuation of controlling interests in business enterprises under the standard of fair value
for financial reporting. The following sections of this VFR Advisory provide commentary on the
definition of fair value and identify the most common instances in financial reporting requiring
measurement of the fair value of controlling interests in business enterprises.
853
The Fair Value Definition
854
855
856
857
858
859
860
861
862
ASC 820, Fair Value Measurement (ASC 820) defines fair value (in its glossary) as “[t]he price
that would be received to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date.”
The definition of fair value and associated guidance create a unique lens through which to view
the valuation of controlling interests in business enterprises. A comprehensive and detailed
review of the fair value definition is beyond the scope of this VFR Advisory and readers are
assumed to have a basic understanding of the standard. However, given the fundamental
significance of fair value to the subject of this VFR Advisory, it is important to briefly review a
number of key fair value concepts.
863
Exit Price
864
865
866
867
868
869
870
Fair value is defined as the price received to sell an asset; in other words, fair value is an exit
price from the perspective of a market participant holding the asset. In contrast, an entry price
would be the price paid to acquire an asset. Despite the conceptual distinction, entry and exit
prices for a subject controlling interest in a business enterprise may often be indistinguishable.
Nonetheless, valuation specialists should acknowledge that the objective of a fair value
measurement is to determine the exit price as of the measurement date and be alert for situations
in which the exit and entry prices may differ.
871
Principal (or Most Advantageous) Market
872
873
874
875
876
877
According to ASC 820, the assumed transaction underlying the fair value measurement occurs in
the principal market for the subject asset. The principal market is the market with the greatest
volume and level of activity for the asset. Further, the principal market is one to which the
reporting entity has access at the measurement date. In the absence of a principal market, ASC
820 specifies that fair value should be measured as the price in the market in which the price
received to sell the subject asset is maximized (the most advantageous market).
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
37
878
879
880
881
882
With respect to controlling interests in business enterprises, the Working Group believes that the
principal market is that for mergers and acquisitions, in which strategic, financial, and
conglomerate buyers evaluate controlling interests in business enterprises considering the
economic benefits expected from ownership of such interests in the context of the perceived risk
and expected rewards of the investment.
883
Market Participants
884
885
886
887
888
889
890
891
892
893
894
895
896
897
898
899
900
901
902
903
904
ASC 820 defines market participants as buyers and sellers in the principal (or most
advantageous) market for the subject asset. First, market participants are assumed to possess
sufficient knowledge regarding the subject asset. In other words, market participants are
competent to assess and understand information regarding the subject asset that would be
obtained through usual and customary due diligence. This attribute of market participants also
implies that the subject asset has had appropriate exposure to the relevant market.
Second, market participants have the ability and/or financial wherewithal to engage in a
transaction involving the subject asset. In other words, market participants are not subject to
external financial constraints that would impinge upon their ability to purchase the subject asset.
Market participants are, however, subject to the internal financial constraint of rational economic
behavior and the requirement that expected return be commensurate with perceived risk. Finally,
market participants are willing to transact for the subject asset. Market participants are motivated
to transact by potential financial returns, but are not under any external compulsion or force.
Fair value is to be measured from the perspective of market participants, and valuation inputs
observed directly from the behavior of market participants are given greater weight than those
that are unobservable. Even when specifying unobservable inputs, valuation specialists are
required by the guidance in ASC 820 to make assumptions consistent with the assumptions
market participants would make, not necessarily those of the reporting entity.
The Working Group elected to introduce the MPAP in this VFR Advisory, in part, to emphasize
the importance of market participants’ perspectives when measuring the fair value of a
controlling interest in a business enterprise.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
38
905
Highest and Best Use
906
907
908
909
910
911
912
913
914
915
The fair value of nonfinancial assets (such as controlling interests in business enterprises) is
measured with respect to the highest and best use of the assets; for business enterprises, the
highest and best use of the underlying assets is evaluated from the perspective of market
participants. ASC 820 states that the value of nonfinancial assets may be maximized by their use
(1) in conjunction with other assets and liabilities (previously referred to as the “in use” valuation
premise), or (2) on a stand-alone basis (previously referred to as the “in exchange” valuation
premise).19 ASC 820 stipulates that, when measuring the fair value of a nonfinancial asset, the
asset’s highest and best use should be evaluated from the market participants’ perspective, even
if such use differs from that intended by the reporting entity. The assumed highest and best use of
the asset should be physically possible, legally permissible, and financially feasible.
916
Asset Characteristics
917
918
919
920
921
922
923
924
925
Fair value measurement should incorporate those characteristics of the subject asset that market
participants would consider in valuing the asset, such as condition and location. With respect to
an ownership interest in a business enterprise, the degree of control vested in the interest is a
relevant characteristic that would be considered by market participants and should, therefore, be
reflected when measuring fair value. Transaction costs are not characteristics of the subject asset
and, hence, should not be considered when measuring fair value, although transactions costs are
considered when identifying the most advantageous market.
ASC 820 clarifies, however, that entity-specific assumptions that are not consistent with the
market participants’ perspective are not relevant to fair value measurement.
926
Fair Value Measurements of Controlling Interests in Business Enterprises
927
928
929
930
931
932
933
934
As noted in the previous section, the relevance of a valuation adjustment such as the MPAP in
measuring fair value is determined by the characteristics of the subject asset that would be
considered by market participants in valuing the asset. The boundaries of the subject asset are
delineated with respect to the unit of account, defined in ASC 820 (the glossary) as “the level at
which an asset or liability is aggregated or disaggregated in a Topic for recognition purposes.”
Three instances have been identified where the value of a controlling interest might need to be
estimated: goodwill impairment testing; portfolio valuation; and accounting for business
combinations in step acquisitions (Step Transactions).
19 ASU 2011-04 clarifies that the concepts of “highest and best use” and “valuation premise” do not apply to
financial assets or liabilities.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
39
935
Goodwill Impairment Testing
936
937
938
939
940
941
942
943
944
945
946
947
948
949
950
951
952
953
The Working Group observes that goodwill impairment testing is the most common fair value
measurement on a controlling interest basis. ASC 350 provides guidance regarding periodic
goodwill impairment testing. The unit of account for such testing is the reporting unit, which is
defined as an operating segment or one level below an operating segment (i.e., a component).
Consistent with the unit of account, ASC 350 acknowledges that the fair value of a controlling
interest in a reporting unit may exceed the Foundation. ASC 350 explicitly acknowledges the
relevance of valuation premiums when measuring the fair value of reporting units. Using the
terminology adopted in this VFR Advisory, an MPAP may be appropriate when measuring the
fair value of a reporting unit. ASC 350 states:
Substantial value may arise from the ability to take advantage of synergies and other benefits
that flow from control over another entity. Consequently, measuring the fair value of a
collection of assets and liabilities that operate together in a controlled entity is different from
measuring the fair value of that entity’s individual equity securities. An acquiring entity often
is willing to pay more for equity securities that give it a controlling interest than an investor
would pay for a number of equity securities representing less than a controlling interest. That
control premium may cause the fair value of a reporting unit to exceed its market
capitalization. The quoted market price of an individual equity security, therefore, need not
be the sole measurement basis of the fair value of a reporting unit.
954
Portfolio Valuation
955
956
957
958
959
960
961
962
963
964
965
966
Investment companies such as private equity funds, hedge funds, and venture capital funds are
generally required to report the fair value of investment holdings in accordance with ASC 946,
Investment Companies (ASC 946). The funds of these companies often own assets that would be
valued using Level 2 or Level 3 inputs under the fair value hierarchy established by ASC 820
because current market prices are not readily available. Due to the often complex ownership
structures of the underlying companies as well as relationships among the investors, the Working
Group believes that understanding control and the related effect on fair value can be particularly
challenging for these investments.
At the date of this writing, the AICPA Private Equity/Venture Capital Task Force was
developing a guide for investment companies.20 It is the Working Group’s understanding that
issues related to control and MPAP for these situations will be discussed, and it is recommended
that readers monitor the development of this guide.
967
Acquisition Method for Step Acquisitions
968
969
In certain transactions, control is gained and business combination accounting is required, but
some portion of the target equity is not acquired by the new controlling owner on the acquisition
20 Valuation of Portfolio Company Investments of Venture Capital, Private Equity Funds and other
Investment Companies.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
40
970
971
972
973
974
975
976
977
978
979
980
981
982
983
984
985
986
987
988
989
990
991
992
993
date. ASC 805 prescribes the accounting treatment for business combinations achieved in stages
(referred to as step acquisitions), as well as for partial acquisitions where control is gained. For
such transactions, the relevant guidance requires the acquirer to measure all of the identifiable
assets and liabilities of the target, any noncontrolling interest in the target that remains in the
hands of the other owners, and any previously held equity interest.
For example, if in the initial step of the transaction the acquirer purchases 60 percent of the
outstanding shares of the target, the acquirer is required to measure the fair value of the
noncontrolling interest held by others (the 40 percent interest not acquired). The fair value of the
noncontrolling interest affects the amount of goodwill (or gain from bargain purchase) at the
acquisition date.
When a noncontrolling interest is present in a transaction, the fair value of that interest may
reflect a potential reduction in value from the pro rata share of the value of the business on a
controlling interest basis. As noted in ASC 805: “The acquirer usually is the combining entity
that pays a premium over the pre-combination fair value of the equity interests of the other
combining entity or entities.” If the market participants for the noncontrolling interest are not
expected to have access to the full range of incremental economic benefits anticipated by the
controlling interest acquirer, the fair value of the noncontrolling interest should reflect the
associated decrement to value. If applicable, incremental return requirements for market
participants evaluating a noncontrolling interest would likewise be expected to reduce the fair
value of the noncontrolling interest.21
Whether the fair value of the noncontrolling shares is measured directly through a valuation
model or through adjustment of the indicated fair value of the controlling interest acquired in the
transaction, the difference between the two fair value measurements should be supported
following the best practices for MPAPs set forth in this VFR Advisory.
994
995
996
997
998
999
1000
1001
1002
1003
1004
1005
We note that in most cases the improvements to a business that are expected to be made by the
controlling shareholder will also benefit the noncontrolling interest. Therefore, it is common that
upon change of control, no value differential arising from control-related issues exists between
controlling and noncontrolling interests. However, certain less common circumstances may arise
that do create such a differential. Some examples of this follow. Acquisition synergies flowing to
an acquirer’s legacy operations where the noncontrolling interest represents an interest in the
newly acquired operations only, such that the noncontrolling interest will not participate in the
value enhancements to the legacy assets. And clearly, if the noncontrolling interest shares have
features that are different from the controlling interest shares, this may also create a value
differential. Also, while full discussion of the topic is not within the scope of this VFR Advisory,
we note for clarity that there is a potential for valuation differential between the noncontrolling
and controlling interests due to differences in marketability.
21 The Working Group notes that if the pro rata fair value of the noncontrolling interest differs from the pro
rata value of the controlling interest, the sum of the two positions will be less than 100 percent of the
enterprise value. In other words, the decrement to the fair value of the noncontrolling interest does not
accrue to the benefit of the controlling interest.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
41
SELECTING AND ASSESSING MARKET PARTICIPANT ACQUISITION
PREMIUMS – EXAMPLES
1006
1007
1008
1009
1010
1011
1012
1013
1014
1015
1016
1017
1018
1019
1020
1021
1022
1023
1024
1025
1026
1027
1028
1029
1030
1031
1032
1033
The following examples are provided to illustrate best practices in both estimating MPAPs and
reviewing the reasonableness of MPAPs implied by a fair value measurement in accordance with
ASC 820.22 The level of analytical detail appropriate to support a given fair value measurement,
and any related MPAP, is a matter of judgment and should be selected with regard to factors
relevant for the accounting measurement under consideration. Relevant factors for consideration
under ASC 350, goodwill impairment testing, would include:
• The magnitude of the premium implied by comparison of the fair value and the market
capitalization (for publicly traded entities). The Working Group believes the higher the
implied premium, the higher level of supporting analysis required.
• The magnitude of the difference between the fair value measurement and the carrying value
of the reporting unit. Larger “cushions” between carrying value and fair value will generally
require less analytical support for the MPAP (whether implied or directly applied). On the
other hand, smaller cushions will generally result in greater scrutiny, indicating that more
analytical detail is appropriate. In cases in which impairment would be indicated but for the
MPAP, valuation specialists should anticipate that auditors will require the most substantive
support of the MPAP.
• The magnitude of the premium implied by the difference between the indicated value under
the discounted cash flow method (using market participants’ control level cash flows) and the
indicated value under the guideline public company method (prior to application of an
MPAP). The greater the implied premium, the more detailed the procedures required to
substantiate the implied premium.
The following examples address two similar fact patterns related to a Step 1 goodwill impairment
test. The first addresses a case in which the MPAP included is critical to the pass/fail result of the
test. The second addresses the same company and basic fact pattern, but assumes a significantly
lower carrying value, resulting in a test for which the MPAP is not a determining factor. Note
that in both examples, the tests are the same in terms of the fundamental methods considered.
However, the level of detail provided in support of MPAP-related assumptions in the second
example is reduced to reflect the lack of MPAP significance in relationship to the test result.
22 The assumed fact pattern was selected to provide the greatest clarity and ease of exposition.
Practitioners are unlikely to encounter exactly such circumstances; however, the Working Group
believes the presentation applies to a broad range of situations.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
42
1034
Conglomerate, Inc. and Subject Co. Reporting Unit
1035
1036
1037
1038
1039
1040
1041
1042
1043
1044
1045
Conglomerate, Inc. (Conglomerate) comprises three wholly owned subsidiaries, each of which is
a separate reporting unit for purposes of ASC 350 compliance. The shares of Conglomerate are
listed on a public exchange. At the date of Conglomerate’s goodwill impairment test, the shares
of Conglomerate traded at $10.00 per share, with 105.0 million shares outstanding and total
interest-bearing debt with a fair value of $817 million. Therefore, market value of invested
capital (MVIC) for Conglomerate is established at $1,867 million. The following discussion will
address the analysis of one of the three reporting units, Subject Co., as well as the overall market
capitalization reconciliation analysis for Conglomerate. The analyses of the second and third
reporting units are not shown here but, for purposes of the market reconciliation discussion, are
assumed to have been performed in a manner similar to that described for Subject Co.
Scenario One Example
1046
Initial MPAP Consideration
1047
1048
1049
As a first step in the analysis of the Subject Co. and other Conglomerate reporting unit fair
values, the general facts and circumstances are reviewed to assess the likely level of importance
of the MPAP to the overall test result. The following facts are observed:
1050
• Conglomerate MVIC: $1,867 million
1051
• The reporting unit carrying values on a TIC basis:
S ubject Co.
Reporting Unit
Reporting
Unit 2
Reporting
Unit 3
Conglomerate
Total
Carrying Values (millions )
$690
$420
$870
$1,980
• Premium over MVIC
$1,980/$1,867 - 1 = 6.1%
if Conglomerate fair value (FV) equals carrying value =
• Aggregate Conglomerate latest twelve months (LTM) Revenue and EBITDA are $1,750
million and $295 million, respectively
• Guideline public company information for Conglomerate as a whole indicates a range of
multiples as follows:
LTM Revenue: .59X – 1.23X
LTM EBITDA: 4.5X to 7.0X
1052
1053
1054
1055
1056
1057
1058
1059
1060
1061
•
Implied multiples if Conglomerate FV equals carrying value =
1062
1063
Carrying value/LTM Revenue: $1,980/$1,750 = 1.13X
Carrying value/LTM EBITDA: $1,980/$295 = 6.71X
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
43
1064
1065
1066
1067
1068
1069
1070
1071
1072
There are two factors that suggest a more robust approach is appropriate. The carrying value-
implied LTM multiples are in the high end of the range of observed guideline company
multiples. This, in combination with the fact that a premium over MVIC is required for
Conglomerate to pass the ASC 350 Step 1 test, indicates that the MPAP is likely to require a
substantial level of support if a passing conclusion is reached for the Step 1 test. Similarly, if the
unit fails, the MPAP will be critical to measuring the concluded impairment amount. Note that
the MPAP and multiples required to pass all reporting units in a Step 1 test are likely to be higher
than the “minimum required” levels calculated in this way as the aggregate company value is not
likely to be distributed in exact proportion to the reporting unit carrying values.
1073
Income Approach – Subject Co.
1074
1075
1076
1077
1078
1079
1080
1081
1082
1083
1084
1085
1086
1087
1088
1089
1090
1091
1092
1093
1094
1095
1096
Following the initial MPAP considerations as described, a discounted cash flow analysis is
performed to obtain a fair value indication for Subject Co. for use in Step 1 of the annual
goodwill impairment test. Consistent with the guidance in ASC 820, the assumptions underlying
this discounted cash flow analysis must reflect the perspective of market participants. Therefore,
all available information is considered in assessing the appropriate cash flow forecast for use in
the analysis. This information includes current management budgeting and forecasting processes,
historical performance levels and historical performance vs. budget/forecast, guideline company
performance metrics, and other specific facts and circumstances relevant to Subject Co.’s
expected performance.
In assessing the appropriate controlling market participants’ forecast, three specific areas of
economic benefit are considered as possibly accruing to the control buyer of Subject Co. and
gather the following information regarding each:
• Revenue Synergies: Research regarding the likely market participants for Subject Co.
indicates that most of the buyers would benefit from revenue synergies related to inclusion of
Subject Co.’s products in the broader, better-marketed product offerings of the buyer
companies. The estimated revenue increase related to this benefit is reflected in higher
revenue growth rates in forecast years one through five of 2.5 percent, 2.5 percent, 2.0
percent, 1.5 percent, and 1.0 percent, respectively. These figures represent incremental
growth above growth expected for Subject Co. on a stand-alone basis. As the market
participant group is dominated by companies that would benefit from this synergy, it is
appropriate to include the related cash flow benefits in the Subject Co. forecast. Note that for
purposes of this example, the simplifying assumption is made that costs are fully variable in
relation to the revenue synergy.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
44
1097
1098
1099
1100
1101
1102
1103
1104
1105
1106
1107
1108
1109
1110
1111
1112
1113
1114
1115
1116
1117
• Operating Expense Savings: The possibility of a control acquisition generating cost savings
from elimination of duplicative support functions and/or economies of scale in purchasing is
considered. However, a high percentage of these expenses are variable in nature and the fixed
portion, which could give rise to acquisition synergies, is insignificant in relation to the value
of Subject Co. Regarding potential economies of scale, the materials and services required by
Subject Co. operations are substantially different from those required in the operations of all
but one of the market participant group. Therefore, no operating expense-related market
participant synergies are included in the Subject Co. forecast.
• Cost of Capital: The Company’s credit rating is below that of the market participants,
resulting in a higher cost of debt. It is determined that market participants would approach
pricing decisions regarding Conglomerate or the separate reporting units using cost of debt
assumptions in line with their own long-term financing costs as the target operations would
be closely integrated with the buyers’ existing operations and financial risk would be
reduced. Therefore, in estimating the appropriate Weighted Average Cost of Capital (WACC)
for use in the Subject Co. analysis, the cost of debt is reduced to the observed market
participants’ level to reflect the economic benefits of acquisition relative to financing
synergies.
As shown in Exhibit A (see appendix), the indicated fair value of the Subject Co. total invested
capital indicated by the discounted cash flow analysis is $740 million. This analysis has been
simplified for the purposes of this VFR Advisory, and it is assumed that commonly accepted
valuation methods and procedures would be followed in the determination of fair value.
1118
Market Approach – Subject Co.
1119
1120
1121
1122
1123
1124
1125
1126
1127
1128
1129
1130
1131
1132
1133
Where meaningfully comparable market information is available, it should be included in the fair
value analysis. The following exhibit includes a form of market approach analysis, which is
included in the determination of the final value conclusion for Subject Co. on a controlling basis.
The income and market approaches should be used in a detailed, quantitative manner in instances
where the MPAP is significant to the accounting outcome (assuming sufficient and reliable
information is available to perform both approaches). In instances where the MPAP is not
significant to the accounting outcome, the Working Group believes that best practices would still
include consideration of both income and market value concepts, but would allow for a less
detailed, qualitative application of one or more portions of the analysis. This fact pattern is
discussed in the Scenario Two example in a subsequent section. Note that where guideline
transaction data is available, it should be used in line with standard valuation practices. However,
for purposes of simplification of this VFR Advisory, the transaction method has been omitted
and only the guideline public company method of the market approach is shown.
The following table summarizes relevant performance and valuation measures for the group of
guideline public companies and the resulting TIC Foundation Value for Subject Co.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
45
Guideline Public Company Data
LTM
Revenue
LTM
EBITDA
Projected
EBITDA
Margin
Est. 5-Yr
Revenue
Growth
$5,220
$893
$2,508
$408
$1,170
$29,000
$5,100
$13,200
$2,400
$9,000
$9,000
$11,740
18.0%
17.5%
19.0%
17.0%
13.0%
17.5%
16.9%
5.0%
6.0%
5.0%
4.5%
-2.0%
5.0%
3.7%
Market
Value
(Invested
Capital)
$31,320
$6,248
$13,794
$2,040
$5,265
MVIC /
Revenue
MVIC /
EBITDA
1.08
1.23
1.05
0.85
0.59
1.05
0.96
6.0
7.0
5.5
5.0
4.5
5.5
5.6
Company A
Company B
Company C
Company D
Company E
MEDIAN
AVERAGE
Subject Company
Selected Multiple
$600
$93
17.0%
6.1%
1.10
6.5
Value Indications
Value B as ed on LTM Revenue
Value B as ed on LTM E B ITDA
Concluded Value - Marketable, Noncontrol Basis (TIC Foundation Value)
$660
$605
$630
Note: All in US$ Millions
1134
1135
1136
1137
1138
1139
1140
Using this information, additional analysis of the guideline company characteristics and other
traditional market approach considerations not shown, it is determined that revenue and EBITDA
multiples appropriate for application in the fair value analysis of Subject Co., as indicated by the
guideline public company analysis, are 1.10X and 6.5X, respectively. These multiples are based
on characteristics of Subject Co. under current stewardship. A Subject Co. TIC Foundation Value
indication of $630.0 million is concluded. The application of an MPAP to this Foundation Value
is then considered to obtain a market-derived value indication on a controlling basis.23
1141
MPAP Estimation – Cash Flow Value
1142
1143
1144
1145
A first step in determining the MPAP for application to the market-derived Foundation Value is a
review of the market participants’ acquisition synergies included in the cash flow analysis, as
described in the Income Approach section above. The range of market premiums paid in recent
control acquisitions of public companies is also reviewed.
23 A discussion of the treatment of cash is beyond the scope of this Advisory. However, it generally is
agreed that excess (nonoperating) cash should be excluded from a value to which an MPAP would be
applied.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
46
1146
1147
1148
1149
1150
1151
1152
1153
1154
1155
To quantify the premium implied by the market participants’ synergies included in the cash flow
analysis, a second cash flow analysis is run excluding these benefits. This analysis, shown in
Exhibit B (see appendix), eliminates the revenue growth enhancements described for years one
through five related to inclusion of Subject Co.’s products in the broader, better-marketed
product offerings of the market participants. This analysis also shows an increase in the discount
rate from 10.0 percent to 10.5 percent, reflecting the elimination of the debt financing benefits
attributable to acquisition.
The following table compares the metrics underlying the cash flow-based fair value measurement
of Subject Co. with those underlying the Foundation Value cash flow analysis, as derived from
comparison of the market participants’ and Foundation cash flow analyses (Exhibits A and B).
E xpected 5-yr Compound Annual Revenue Growth
Gros s P rofit Margin
Operating E xpens es :
Res earch & Development
Dis tribution E xpens es
S elling E xpens es
Other General & Adminis trative
E B ITDA Margin
Weighted Average Cos t of Capital
Total Inves ted Capital Value
TIC / Trailing Revenue
TIC / Trailing E B ITDA
MPAP Implied by the Cash Flow Analyses
Foundation
Value
Fair
Value
6.1%
60.0%
5.0%
13.5%
17.5%
7.0%
17.0%
10.5%
$660
1.1
7.1
8.0%
60.0%
5.0%
13.5%
17.5%
7.0%
17.0%
10.0%
$740
1.2
8.0
12.1%
1156
1157
1158
Based on the results shown, the MPAP indicated by the cash flow analyses described is 12.1
percent on a TIC basis (21.6 percent on an equity basis at Conglomerates’ actual debt/equity ratio
of 44/56).24
1159
Observed Transaction Premiums
1160
1161
1162
1163
Consideration of premiums observed in guideline transactions is often appropriate; however,
such comparisons should be made carefully.
Observed transaction premiums (using an Equity Foundation, as traditionally stated) for three
guideline transactions range from 25.0 percent to 58.7 percent, as shown below.
24 Equity Premium% = (TIC Premium%)/(Equity%) = 12.1% / 56.0% = 21.6%
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
47
Guideline Control Premiums
Transaction
Price Per
Share
Company F
Company G
Company H
$37.50
$61.00
$25.00
MEDIAN
AVERAGE
Transaction Interest Transaction Unaffected Transaction Transaction
Observed
Observed
Shares
Outstanding
53.7
105.9
240.8
Value
(Equity)
$2,013
$6,460
$6,020
Bearing
Debt
$3,500
$2,900
$1,000
Value
(TIC)
Price Per
Share
Premium
(Equity)
Premium
(TIC)
$5,513
$9,360
$7,020
$30.00
$45.00
$15.75
25.0%
35.6%
58.7%
35.6%
39.8%
7.9%
22.1%
46.5%
22.1%
25.5%
Note: All in US$ Millions Except Per Share Amounts
1164
1165
1166
1167
1168
1169
1170
1171
1172
1173
1174
1175
1176
1177
1178
1179
1180
1181
1182
1183
1184
1185
This fact pattern demonstrates that relying only on observed transaction premiums to support a
concluded or implied MPAP is potentially misleading. Since such premiums have traditionally
been expressed as a percentage of Equity Foundation, differences in leverage between Subject
Co. and the acquired companies can produce unreliable fair value measurements. For example,
Company F is highly leveraged, causing the observed premium using an Equity Foundation to be
materially higher than when expressed as a percentage TIC Foundation. When sufficient data is
available to permit the calculation, expressing premiums as a percentage of total invested capital
provides a more reliable basis of comparison across companies and is consistent with best
practices. When expressed on a total invested capital basis, the implied premium for Subject Co.
is 12.1 percent.
If an analyst compared the equity-based MPAP for Subject Co. (21.7 percent) to the range of
observed equity-based premiums for the guideline transactions (25.0 percent to 58.7 percent), the
analyst might conclude that the fair value of Subject Co. is understated. However, on a total
invested capital basis, the implied MPAP for Subject Co. falls within the range of the guideline
premiums.
Each acquiree presents a different set of potential economic benefits that may or may not be
comparable to those of Subject Co. For example, assume Company H reported a historical
EBITDA margin of 13 percent, below that of Subject Co. and at the low end of the public peer
group. The relatively low margins of Company H may correspond to superior cash flow
enhancement opportunities, and therefore a higher MPAP. In this instance, applying an MPAP
equal to the transaction premium observed for Company H to Subject Co. would potentially
result in an overstatement of fair value.25
25 The Working Group observes that it may be appropriate to augment such analysis with a multi-year
perspective on financial results.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
48
1186
1187
1188
1189
1190
1191
1192
However, as discussed earlier, observed transaction premium data may be informative. The
observed transaction premiums provide a composite view of the control benefits of cash flow
enhancements and/or lower required rates of return perceived by the acquirers in the observed
transactions. This may help to establish the reasonableness of the cash flow benefits assumed (or
implied) by the fair value measurement under consideration. However, exclusive reliance on
observed transaction premiums without careful analysis of relative financial performance,
valuation multiples, and other metrics can result in an unreliable fair value measurement.
1193
MPAP Conclusion
1194
1195
1196
1197
1198
1199
1200
Multiple cash flow and cost of capital sources of MPAP for Subject Co. were reviewed, as well
as the range of premiums observed in relevant recent transactions. Based on this analysis, a TIC-
basis MPAP of 12 percent is selected for application in the guideline company market approach.
This determination is supported primarily by the cash flow synergies that market participants
would be expected to consider in pricing an acquisition of Subject Co. Additional supporting
evidence was shown in the effects on the WACC as well as recent market transaction premiums
paid for similar companies.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
49
1201
Subject Co. Fair Value Conclusion
1202
1203
Based on the income and market analyses described, a fair value of $725.0 million is concluded
for Subject Co., which passes the Step 1 ASC 350 test, as follows:
Control Value Indication: Income Approach
Minority, Noncontrol Indication: Market Approach
Concluded MP AP , TIC B as is
Control Value Indication: Market Approach
Concluded F air Value of S ubject Co.
Carrying Value: S ubject Co.
AS C 350 P as s /(F ail)
P as s P ercentage
Note: All in US$ Millions
$740.0
$630.0
12.0%
$705.6
$725.0
$690.0
$35.0
5.1%
Pass
1204
Reconciliation to Market Capitalization
1205
1206
1207
1208
1209
1210
1211
1212
1213
Conglomerate is a publicly traded company comprising three reporting units. Following the
procedures described for the Subject Co. reporting unit, fair values have been estimated for each
of the three units. The total concluded value of all three of the Conglomerate reporting units is
$2,080 million and all three units are concluded to have passed the Step 1 test. A critical step in
the valuation specialist’s review of the reasonableness of the initial conclusions is a
reconciliation of the results to Conglomerate’s market value.
The MVIC of Conglomerate as of the testing date, as described in the Initial MPAP
Consideration section above, is $1,867 million. Therefore, the premiums implied by the initial
value conclusions are as shown in the following table.
Concluded F air Value of Conglomerate TIC (s um of reporting units )
$2,080.0
Tes t Date P rice of Conglomerate S hares
Outs tanding Conglomerate S hares (millions )
Conglomerate E quity Market Capitalization
F air Value of Conglomerate Debt
MVIC of Conglomerate
MP AP Implied by F air Value Conclus ion
MP AP Implied by F air Value Conclus ion (E quity F oundation bas is )
MP AP Implied by F air Value Conclus ion (TIC F oundation bas is )
$10.0
105.0
$1,050.0
$817.0
$1,867.0
$213.0
20.3%
11.4%
Note: All in US$ Millions Except Price Per Share
The Working Group notes that, as a practical expedient, adjus tments are not
made to account for normalized operating levels of cas h.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
50
1214
1215
The reconciling 11.4 percent TIC Foundation MPAP (20.3 percent on an Equity basis) is shown
to be reasonable based on the following:
1216
1217
• Specific cash flow benefits analysis (the cash flow benefits seen in the value differential
supported in Exhibits A and B)
1218
• Cost of capital benefits of acquisition described for Subject Co.
1219
1220
Note that the economic benefits described for Subject Co. reporting unit are also assumed to be
present at the same approximate level in the other reporting units not shown.
1221
1222
1223
1224
1225
1226
1227
1228
1229
1230
Scenario Two Example
As discussed above, determination of the level of detail appropriate to support MPAP
assumptions is based on the likely significance of the MPAP in relationship to the test result. For
example, if it is unlikely that the MPAP will be a determining factor in the pass/fail result of an
ASC 350 Step 1 test, then the level of detail may be reduced from that included in the analysis
shown in the Scenario One example in the prior section. To illustrate this concept, the Scenario
One example is reconsidered with revision to the carrying values of the reporting units. The
carrying value revisions, which represent the only change to the Subject Co. fact pattern
described previously, are shown in the following table:
S ubject Co.
Reporting Unit
Reporting
Unit 2
Reporting
Unit 3
Conglomerate
Total
Carrying Values (millions )
Revis ed for S cenario Two
$440
$350
$500
$1,290
1231
Initial MPAP Consideration (revised carrying value example)
1232
1233
1234
1235
1236
1237
1238
1239
With the lower carrying values shown, the valuation specialist’s first step assessment of the
likely level of importance of the MPAP to the overall test result provides the following revised
fact pattern:
• Conglomerate MVIC: $1,867 million (unchanged)
• The reporting unit carrying values on a TIC basis:
S ubject Co.
Reporting Unit
Reporting
Unit 2
Reporting
Unit 3
Conglomerate
Total
Carrying Values (millions )
$440
$350
$500
$1,290
• Premium over MVIC if Conglomerate FV equals carrying value = $1,290/$1,867 - 1 =
-30.9%
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
51
1240
1241
1242
1243
1244
1245
1246
1247
1248
1249
1250
1251
1252
1253
1254
1255
1256
1257
1258
1259
1260
1261
1262
1263
1264
1265
1266
1267
1268
1269
1270
1271
1272
1273
1274
• Aggregate Conglomerate LTM Revenue and EBITDA are $1,750 million and $295
million, respectively (unchanged)
• Guideline public company information for Conglomerate as a whole indicates a range of
multiples as follows (unchanged):
LTM Revenue: .59X – 1.23X
LTM EBITDA: 4.5X to 7.0X
•
Implied multiples if Conglomerate FV equals carrying value =
Carrying value/LTM Revenue: $1,290/$1,750 = 0.74X
Carrying value/LTM EBITDA: $1,290/$295 = 4.37X
In this revised example, given the lower carrying values, the minimum premium over MVIC that
would be required for Conglomerate to pass the ASC 350 Step 1 test shows a large cushion of
over 30 percent, indicating that there is a reasonable possibility that each unit could pass the test
before consideration of the MPAP. Additionally, the carrying value-implied LTM multiples are
at or below the bottom end of the range of observed guideline company multiples. Therefore, the
MPAP is unlikely to have any bearing on the outcome of the subject impairment test and the
initial analysis of the reporting unit fair values is run with minimal supporting detail for the
MPAP.
The analysis of the Subject Co. fair value follows the same general process in this revised
scenario as that shown in the Scenario One example. The differences in the details of the various
steps in the analysis are summarized as follows:
•
Income Approach: In establishing the forecast for use in the cash flow analysis, the same
areas of potential acquisition synergy are considered as those described in the Scenario One
example. However, the objective in doing so is only to establish that the types of synergies
included represent appropriate market participants’ assumptions. No specific quantification
of the market participants’ synergies is needed for purposes of quantifying the MPAP.
However, it may be necessary to understand and quantify the market participants’ synergies
as an element of PFI when performing the valuation.
• Market Approach: The guideline public company analysis is performed in the same manner
as shown in the Scenario One example through the point of estimation of the Foundation
Value.
• MPAP Estimation: The estimation of the MPAP for application to the Foundation Value is
then based only on a review of the guideline transaction premium information. The cash
flow-based MPAP estimation process shown in the Scenario One example is eliminated as
unnecessary, pending review of the fair value results for each reporting unit relative to its
respective carrying value.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
52
1275
1276
1277
The results of the test under this revised scenario are shown in the table below. A fair value of
$730.0 million is concluded for the Subject Co. reporting unit, and Subject Co. passes the Step 1
ASC 350 test, as follows:
Control Value Indication: Income Approach
Minority, Noncontrol Indication: Market Approach
Concluded MP AP , TIC B as is
Control Value Indication: Market Approach
Concluded F air Value of S ubject Co.
Carrying Value: S ubject Co.
AS C 350 P as s /(F ail)
P as s P ercentage
Note: All in US$ Millions
$740.0
$630.0
15.0%
$724.5
$730.0
$440.0
$290.0
65.9%
Pass
1278
1279
1280
1281
The cushion of $290 million represents a wide (66 percent) margin over the Subject Co. carrying
value. Therefore, results shown for Subject Co. clearly indicate that further, more detailed
support for the MPAP is unnecessary for purposes of this analysis as the reporting unit passes the
test by a margin well in excess of the 15 percent premium included.
1282
Regarding this more simplified analysis, the Working Group notes the following observations:
1283
1284
1285
1286
1287
1288
1289
1290
1291
1292
1293
1294
1295
1296
1297
• The control value concluded for the market approach in this example ($724.5) is higher than
that concluded in the more detailed Scenario One example ($705.6).
• The 15 percent MPAP, while within the range of market evidence from the exhibit on
page 48, is lower than the average or median, reflecting consideration of the challenges
regarding the transaction premium data discussed elsewhere in this Advisory.
•
If the indicated average or median transaction premium from the market evidence on page 48
were simply used, the spread between the conclusion from the “detailed analysis” and the
“simplified analysis” would be even greater. This suggests that the “simplified analysis”
could be overstating fair value.
• This result provides further evidence of the need for precaution in relying exclusively on the
historical transaction premium data. Use of this data should be supported conceptually by
characteristics of the subject entity that would influence the extent of a reasonable MPAP
such as the qualitative factors discussed in the earlier section—Business Characteristics
Influencing Market Participant Acquisition Premium—to narrow the range of observed
premiums from the transaction data that may be applicable for the subject entity.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
53
1298
Reconciliation of Market Capitalization (revised carrying value example)
1299
1300
1301
1302
1303
1304
The MVIC of Conglomerate as of the testing date is unchanged at $1,867 million. The fair value
conclusions for each of the reporting units have all been derived in the same manner as that
described here in the Scenario Two revised carrying value example for Subject Co. and all three
units are concluded to have passed the Step 1 test. The resulting total concluded value of the
Conglomerate TIC is $2,150,000. Therefore, the premiums implied by the value conclusions are
as shown in the following table.
Concluded F air Value of Conglomerate TIC (s um of reporting units )
$2,150.0
Tes t Date P rice of Conglomerate S hares
Outs tanding Conglomerate S hares (millions )
Conglomerate E quity Market Capitalization
F air Value of Conglomerate Debt
MVIC of Conglomerate
MP AP Implied by F air Value Conclus ion
MP AP Implied by F air Value Conclus ion (E quity F oundation bas is )
MP AP Implied by F air Value Conclus ion (TIC F oundation bas is )
$10.0
105.0
$1,050.0
$817.0
$1,867.0
$283.0
27.0%
15.2%
Note: All in US$ Millions Except Price Per Share
The Working Group notes that, as a practical expedient, adjus tments are not
made to account for normalized operating levels of cas h.
1305
1306
1307
1308
1309
1310
The reconciling 15.2 percent TIC Foundation MPAP (27.0 percent on an Equity basis) is shown
to be reasonable. This determination is based on the general level of premiums observed in recent
transaction premiums. While this type of support would not be sufficient in a case where a
premium is necessary to the support the test results, the fact that no premium is required to
establish a passing result for any of the Conglomerate reporting units allows for this more
efficient, less detailed approach in this case.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
54
SUMMARY
1311
1312
1313
1314
1315
1316
1317
1318
1319
1320
1321
1322
1323
1324
1325
1326
1327
1328
1329
1330
1331
1332
1333
1334
1335
1336
1337
1338
1339
1340
1341
1342
1343
1344
1345
1346
Because this VFR Advisory is intended to address best practices for the valuation of controlling
interests in business enterprises under the standard of fair value for financial reporting, certain
commentary is provided regarding this context.
In fulfilling its mandate to provide best practices in the context of measuring fair value for
financial reporting purposes, the Working Group introduced the term Market Participant
Acquisition Premium, or MPAP. MPAP is defined here as the difference between: (1) the pro
rata fair value of the subject controlling interest; and (2) its foundation. The Working Group
believes that valuation specialists most commonly associate the foundation with the pro rata fair
value of marketable, noncontrolling interests in the enterprise. While this describes an MPAP
Equity Foundation concept, a TIC Foundation may be more appropriate. The Working Group
believes that best practices include expressing as well as applying the MPAP in the context of a
TIC Foundation.
This Advisory asserts that MPAPs should be supported by reference to either enhanced cash
flows or a lower required rate of return from the market participants’ perspective. The Working
Group anticipates such benefits will not in all instances exist or be reliably identifiable, thus, in
such cases resulting in either no premium or a small premium. Notwithstanding the emphasis on
cash flow and risk differentials in supporting MPAPs in fair value measurement, the Working
Group acknowledges the merit of analyzing historical data regarding observed premiums from
closed transactions when reliable data is available.
However, the Working Group cautions that exclusive reliance on observed premium data from
completed transactions provides, in most cases, insufficient support for a concluded MPAP.
Exclusive reliance on observed transaction premiums without careful analysis of the subject
entity’s relative financial performance, valuation multiples, and other metrics can result in an
unreliable fair value measurement.
Various business characteristics are discussed that influence an MPAP, including characteristics
of the market and industry, as well as both the subject entity and market participants. The
exercise of prerogatives of control by acquirers may lead to economic benefits in many areas and
the valuation specialist should review the typical business characteristics likely to influence the
magnitude of the benefits available to market participants. The Working Group believes that use
of the framework discussed will provide an important context for review of the valuation results
and will increase the relevance and reliability of the associated fair value measurement.
A credible fair value measurement should include an assessment of the overall reasonableness of
the measurement, including the MPAP applied or implied by the analysis. The level of rigor of
analysis would depend on the importance of the MPAP to the fair value measurement.
Factors—along with examples—are offered to evaluate the reasonableness of the fair value
measurement of a controlling interest in a business enterprise.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
55
EXHIBITS A AND B
EXHIBIT A
Market P articipant P ers pective - C ontrolling Interes t
(in US $ millions )
C ompound Annual Growth R ate (R evenue, Through Year 5):
8.0%
Trailing
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
R es idual
R evenue
Revenue Growth
$600
$950
$660
10.0%
$719
9.0%
$777
8.0%
$831
7.0%
$881
6.0%
$925
5.0%
$962
4.0%
$996
3.5%
$1,026
$1,057
$1,088
3.0%
3.0%
3.0%
Gros s P rofit
Operating E xpens es :
R es earch & Development
Dis tribution E xpens es
S elling E xpens es
Other General & Adminis trative
Total Operating E xpens es
EBITDA
Depreciation & Amortization
E BIT
Taxes
Debt Free Net Income
Incremental Working C apital
Depreciation & Amortization
C apital E xpenditures
Debt Free C as h Flow
R es idual Value
Dis counting P eriods
P V Factor
P V DFC F
Total Invested Capital Value
Interes t-Bearing Debt
E quity Value
MP AP (E quity)
MP AP (TIC )
Relative Value Measures
TIC / Trailing R evenue
TIC / Trailing E BITDA
360
30
87
105
45
267
93
25
68
27
41
60.0%
5.0%
13.5%
17.5%
7.0%
43.0%
17.0%
40.0%
30.0%
396
33
89
116
46
284
112
25
87
35
52
18
25
25
34
432
36
97
126
50
309
123
26
97
39
58
18
26
26
40
466
39
105
136
54
334
132
29
103
41
62
17
29
29
45
499
42
112
145
58
357
142
32
110
44
66
16
32
32
50
529
44
119
154
62
379
150
35
115
46
69
15
35
35
54
555
46
125
162
65
398
157
38
119
48
71
13
38
38
58
577
48
130
168
67
413
164
40
124
50
74
11
40
40
63
598
50
134
174
70
428
170
43
127
51
76
10
43
43
66
616
51
138
180
72
441
175
45
130
52
78
9
45
45
69
634
53
143
185
74
455
179
47
132
53
79
9
47
47
70
653
54
147
190
76
467
186
49
137
55
82
9
49
49
73
1,000
10.0%
0.9535
0.8668
0.7880
0.7164
0.6512
0.5920
0.5382
0.4893
0.4448
0.4044
0.4044
0.5
1.5
2.5
3.5
4.5
5.5
6.5
7.5
8.5
9.5
9.5
33
35
35
36
35
34
34
32
31
28
404
$740
290
$450
21.6%
12.1%
1.2
8.0
R es idual Value C alculation
R es idual Debt Free C as h Flow
C os t of C apital
E s timated R es idual Growth R ate
R es idual C apitalization R ate
R es idual Value
10.0%
3.0%
$73
7.0%
$1,000
This analysis has been simplified for the purposes of this VFR Advisory. It is assumed that commonly accepted valuation methods and procedures would be followed in the determination of fair value.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
Exhibit A
EXHIBIT B
Forecas t Under C urrent S tewards hip
(in US $ millions )
C ompound Annual Growth R ate (R evenue, Through Year 5):
6.1%
Trailing
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
R es idual
R evenue
Revenue Growth
$600
$950
$645
7.5%
$687
6.5%
$728
6.00%
$768
5.50%
$807
5.00%
$847
5.0%
$881
4.0%
$912
3.5%
$939
3.0%
$967
3.0%
$996
3.0%
Gros s P rofit
Operating E xpens es :
R es earch & Development
Dis tribution E xpens es
S elling E xpens es
Other General & Adminis trative
Total Operating E xpens es
EBITDA
Depreciation & Amortization
E BIT
Taxes
Debt Free Net Income
Incremental Working C apital
Depreciation & Amortization
C apital E xpenditures
Debt Free C as h Flow
R es idual Value
Dis counting P eriods
P V Factor
P V DFC F
Total Invested Capital Value
Interes t-Bearing Debt
E quity Value
Relative Value Measures
TIC / Trailing R evenue
TIC / Trailing E BITDA
360
30
87
105
45
267
93
25
68
27
41
60.0%
5.0%
13.5%
17.5%
7.0%
43.0%
17.0%
40.0%
30.0%
387
32
87
113
45
277
110
25
85
34
51
14
25
25
37
412
34
93
120
48
295
117
26
91
36
55
13
26
26
42
437
36
98
127
51
312
125
29
96
38
58
12
29
29
46
461
38
104
134
54
330
131
32
99
40
59
12
32
32
47
484
40
109
141
56
346
138
35
103
41
62
12
35
35
50
508
42
114
148
59
363
145
38
107
43
64
12
38
38
52
528
44
119
154
62
379
149
40
109
44
65
10
40
40
55
547
46
123
160
64
393
154
43
111
44
67
9
43
43
58
563
47
127
164
66
404
159
45
114
46
68
8
45
45
60
580
48
131
169
68
416
164
47
117
47
70
8
47
47
62
0.5
1.5
2.5
3.5
4.5
5.5
6.5
7.5
8.5
9.5
598
50
134
174
70
428
170
49
121
48
73
9
49
49
64
900
9.5
10.5%
0.9513
0.8609
0.7791
0.7051
0.6381
0.5774
0.5226
0.4729
0.4280
0.3873
0.3873
35
36
36
33
32
30
29
27
26
24
349
$660
290
$370
1.1
7.1
R es idual Value C alculation
R es idual Debt Free C as h Flow
C os t of C apital
E s timated R es idual Growth R ate
R es idual C apitalization R ate
R es idual Value
10.5%
3.0%
$64
7.5%
$900
This analysis has been simplified for the purposes of this VFR Advisory. It is assumed that commonly accepted valuation methods and procedures would be followed in the determination of fair value.
VFR Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums
Copyright © 2017 by The Appraisal Foundation. All rights reserved.
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BEST PRACTICES FOR VALUATIONS
IN FINANCIAL REPORTING:
INTANGIBLE ASSET WORKING
GROUP – CONTRIBUTORY ASSETS
THE IDENTIFICATION OF CONTRIBUTORY ASSETS
AND CALCULATION OF ECONOMIC RENTS
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
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Working Group on Contributory Asset Charges
Anthony Aaron, Chair
Ernst & Young, LLP - Los Angeles, CA
Paul Barnes
Duff & Phelps, LLC - Philadelphia, PA
Jim Dondero
Huron Consulting Group - Boston, MA
Gregory Forsythe
Deloitte Financial Advisory Services LLP - Pittsburgh, PA
Mark Zyla, Vice Chair
Acuitas, Inc. - Atlanta, GA
Jay Fishman, Steering Committee Oversight & Facilitator
Financial Research Associates – Philadelphia, PA
Task Force (Steering Committee) on Best Practices for Valuations in Financial Reporting
Lee Hackett - American Appraisal Associates
Steve Jones - Mesirow Financial
Gerald Mehm - American Appraisal Associates
Matt Pinson – PricewaterhouseCoopers LLP
Jay Fishman, Chair - Financial Research Associates
Anthony Aaron - Ernst & Young, LLP
Paul Barnes - Duff & Phelps, LLC
Carla Glass - Hill Schwartz Spilker Keller LLC
John Glynn - PricewaterhouseCoopers LLP
Contributors & Special Thanks
Dayton Nordin, Ernst & Young, LLP
Gary Roland, Duff & Phelps, LLC
Shawn Suttmiller, Deloitte Financial Advisory Services LLP
Carla Glass, Hill Schwartz Spilker Keller LLC
Lee Hackett, American Appraisal Associates
The Appraisal Foundation Staff
David Bunton, President
John Brenan, Director of Research & Technical Issues
Paula Douglas Seidel, Executive Administrator
The Appraisal Foundation served as a sponsor and facilitator of this Working Group. The Foundation is a non-profit educational organization dedicated
to the advancement of professional valuation and was established in 1987 by the appraisal profession in the United States. The Appraisal Foundation
is not an individual membership organization, but rather, an organization that is made up of other organizations. Today, over 130 non-profit
organizations, corporations and government agencies are affiliated with The Appraisal Foundation. The Appraisal Foundation is authorized by the U.S.
Congress as the source of appraisal standards and appraiser qualifications.
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1
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
TABLE OF CONTENTS
Foreword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.0 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.0 Identification of Contributory Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.1 What Constitutes a Contributory Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.2 Contributory Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
3.0 Valuation Methodologies and the Application of Contributory Asset Charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
3.1 Introduction and General Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
3.2 Working Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.3 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
3.4 Fixed Assets (Not Including Land) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
3.5 Identified Intangible Assets and Contributory Elements of Goodwill (Including Assembled Workforce) . . . . . . . . . . . . . . . . . . . . . . . . 18
3.6 Contributory Asset Charges in Future Periods (or Over Time) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
3.7 Special Adjustments for Growth Investments in Contributory Intangible Assets Valued Using the Cost Approach . . . . . . . . . . . . . . . . . 22
4.0 The Stratification of Rates of Return by Asset or Asset Category . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
4.2 Rate of Return Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
4.3 Issues Pertaining to WACC, IRR and WARA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
5.0 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
6.0 List of Acronyms Used . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
7.0 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
8.0 Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
8.1 Glossary of Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
8.2 Glossary of Entities Referred to in Document . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
9.0 Appendix A: Comprehensive Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
10.0 Appendix B: Practical Expedient . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
11.0 Appendix C: Pre-tax versus After-tax Adjustments for Growth Investments in Certain Intangible Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
2
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FOREWORD
This document regarding best practices for The Identification of Contributory Assets and Calculation of Economic Rents was developed by a working group
sponsored by The Appraisal Foundation.
With changing financial reporting requirements, there is increased interest in the effect of valuation conclusions on financial statements. Because of the
need for financial statements to be both reliable and relevant, valuation practices must provide reasonably consistent and verifiable value conclusions.
To this end, the valuation community believed that guidance regarding best practices surrounding certain specific valuation topics would be helpful. The
topics are selected based on those in which the greatest diversity of practice has been observed.
The Appraisal Foundation sponsored this endeavor as an independent body interested in the advancement of professional valuation and whose stated goal
is assuring public trust in the valuation profession. The Appraisal Foundation convened a series of working groups to develop guidance to assist in reducing
diversity in practice in valuations performed for financial reporting purposes.
This document presents best practices for the first topic, The Identification of Contributory Assets and Calculation of Economic Rents, and was created by
the first Working Group. This final document follows the issuance of a discussion draft on June 10, 2008 and an exposure draft on February 25, 2009,
as well as a public hearing for oral comments on May 12, 2009, and reflects full consideration of all comments received.
This document includes a Comprehensive Example as well as a Practical Expedient as Appendices. While creating these Appendices, the first Working
Group also created a “Toolkit,” which is an expansion of the Comprehensive Example. The Toolkit contains additional sample spreadsheets that illustrate
application of typical calculations in which contributory asset charges are used. It will be published under separate cover.
The Identification of Contributory Assets and Calculation of Economic Rents was developed by a Working Group comprising individuals from the valuation
profession who regularly deal with this issue in the context of valuations performed for financial reporting purposes. Its conclusions reflect what the
developers believe are best practices. This document has no official or authoritative standing for valuation or accounting.
This document was approved for publication by the Board of Trustees of The Appraisal Foundation on May 22, 2010. The reader is informed that the Board
of Trustees defers to the members of the contributory asset Working Group for expertise concerning the technical content of the document.
Questions on the development of this document can be addressed as follows:
Paula Douglas Seidel
The Appraisal Foundation
1155 15th Street NW, Suite 1111
Washington, DC 20005
202.624.3048 (phone); 202.347.7727 (fax); paula@appraisalfoundation.org (email)
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3
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
1.0 Introduction
1.1 This document setting forth best practices for The Identification of Contributory Assets and Calculation of Economic Rents (“Monograph”) is
the result of deliberations by the Working Group on Contributory Asset Charges (“CACs”) and input received from interested parties.
1.2 CACs (also known as capital charges or economic rents) are a requisite consideration in applying the Multi-Period Excess Earnings Method
(“MPEEM”)1 to estimate the fair value of a subject intangible asset.
1.3 The MPEEM is a method under the income approach. In applying this form of analysis, the starting point is generally Prospective Financial
Information (“PFI”) for the entity that owns the subject intangible asset. From this, a stream of revenue and expenses are identified as those
associated with a particular group of assets. This group of assets includes the subject intangible asset as well as other assets (contributory
assets) that are necessary to support the earnings associated with the subject intangible asset. The prospective earnings of the single subject
intangible asset are isolated from those of the group of assets by identifying and deducting portions of the total earnings that are attributable
to the contributory assets to estimate the remaining or “excess earnings” attributable to the subject intangible asset. The identification of
earnings attributable to the contributory assets is accomplished through the application of CACs in the form of returns “on” and, in some cases,
“of” the contributory assets. These CACs represent an economic charge for the use of the contributory assets. The “excess” earnings (those that
remain after subtraction of the CACs) are attributable to the subject intangible asset. These excess earnings are discounted to present value at
an appropriate rate of return to estimate the fair value of the subject intangible asset. Thus, the MPEEM could be described as an attribution
model under the income approach.
1.4 Expressed in a slightly different manner, when PFI is used to determine the fair value of a subject intangible asset it might include
contributions from a number of different assets working together as a group. To arrive at the excess earnings solely attributable to the subject
intangible asset, the valuation specialist needs to identify other assets that are contributing to the generation of the asset group’s earnings.
If the specific revenues and expenses of these other assets cannot be separated from the PFI for the group of assets, the subtraction of CACs
is necessary to recognize the economic benefit provided by the contributory assets. If the contribution of these assets is separated from the
group’s aggregate PFI, then CACs are not necessary.
1.5 Whether CACs are theoretically viewed as an attribution of earnings to a contributory asset owned by the entity or as a payment for use
assuming the contributory asset is owned by a third party, the fundamental premise is that a contributory asset must be assigned a portion of
the economic earnings of the group of assets to derive the excess earnings attributable to the subject intangible asset.
1.6 A fundamental attribute of the MPEEM and of CAC calculations relates to a basic principle of financial theory known as Return on Investment
(“ROI”). From the perspective of an investment in contributory assets, an owner of such assets would require an appropriate ROI. The ROI, in
turn, consists of a pure investment return (what is referred to herein as return on) and a recoupment of the original investment amount (what
is referred to herein as return of). Thus the most basic underpinning of CAC calculations is that contributory assets should earn a fair ROI.
1 This term was introduced and is used in the 2001 AICPA Practice Aid Series: “Assets Acquired in a Business Combination to Be Used in Research and Development
Activities: A Focus on Software, Electronic Devices and Pharmaceutical Industries”. (An update of this Practice Aid was underway as of the finalization of this Monograph.)
4
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1.7 The distinguishing characteristic of a contributory asset is that it is not the subject income-generating asset itself; rather it is an asset that
is required to support the subject income-generating asset. The CAC represents the charge that is required to compensate for an investment in
a contributory asset, giving consideration to rates of return required by market participants investing in such assets.
1.8 During the Working Group’s discussions and the public hearing, it became apparent that it was necessary to define the specific scope of
this Monograph. The discussion of CACs requires the understanding of many accounting and valuation requirements and methods. Discussion
of these requirements and methods is beyond the scope of the CAC Monograph and the reader is assumed to already have this understanding.
More specifically, this Monograph assumes the reader has sufficient understanding of the following issues:
A.
The PFI used in the MPEEM is to reflect market participant assumptions. This Monograph does not address the identification of
market participants or include a detailed discussion of all adjustments to the PFI potentially required to reflect such assumptions.
B.
The application of a specific valuation approach, method, or technique to an asset is based on facts and circumstances from a market
participant perspective, and the reader is assumed to have the ability to make this judgment. This Monograph does not discuss the
variety of approaches, methods, and techniques or the judgment required to select one. Those applied to any of the assets identified
herein are provided for demonstration purposes only.
C.
The discussions in this Monograph as well as the Comprehensive Example and Practical Expedient included in Appendices A and B,
respectively, make certain assumptions that might impact the valuation of the contributory assets. Assumptions used in the valuation
of an asset are based on facts and circumstances and the reader is assumed to have the ability to make these judgments. The
assumptions reflected in the discussions and examples contained in this Monograph are for demonstration purposes only. General
principles have been provided for guidance to assist in the calculation of CACs in the application of the MPEEM.
D.
The models used in the sample calculations are for demonstration purposes only and are not intended as the only form of model or
calculation, or final report exhibit, that is acceptable. In some cases, these models include details to demonstrate a point made in
this Monograph and would not be expected in a typical analysis.
1.9 In writing this document, the Working Group recognizes that professional judgment is critical to effectively planning, performing, and
concluding a valuation. Professional judgment requires both competency (appropriate knowledge and experience) and ethical behavior
(objectivity and independence). Questioning and skepticism are appropriate because of the nature of judgments. Knowledgeable, reasonable,
objective individuals can reach different conclusions for a given set of facts and circumstances. Professional judgment reflects a process of fact-
gathering, research, and analysis employed while reaching well-reasoned conclusions based on relevant facts and circumstances available at
the time of the conclusion.
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5
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
1.10 The following important clarifications regarding this document are also made:
A.
These best practices have been developed with reference to US GAAP effective as of the date that this document was published. While
the Working Group believes that the best practices described herein may have application outside of US GAAP the valuation specialist
should not apply these best practices to valuations prepared under different applicable standards/statutory requirements without a
thorough understanding of the differences between them and US GAAP guidance existing as of the date of this publication.
B.
The Working Group has not used the terms “cash flow,” “earnings” and “income” as commonly used in the accounting literature.
When the terms “cash flow,” “earnings” or “excess earnings” are used, they refer to an “economic earnings” concept associated with
the netting of expense and other charges against revenue.
C.
The Working Group recognizes that there is often a difference between the total amount of goodwill recorded as the result of an
acquisition and the amount of goodwill (or “excess purchase price”) that the valuation specialist is typically dealing with during the
valuation. For example, an amount is typically recorded to deferred taxes and this amount is not defined until after the work of
the valuation specialist is completed. However, the term goodwill is used in this document in both situations to mean the difference
between the purchase price being used (either during the valuation process or the recording process) and the net value of all
separately recognized assets and liabilities.
D.
The terms “value,” “valuation,” “valuing,” “fair value” and any other reference to value throughout this document are intended, for
the purposes of this document, to be stated in accordance with “fair value” as defined in the Financial Accounting Literature, Financial
Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 820 (formerly FASB Statement of Financial
Accounting Standards No. 157 (“FASB Statement No. 157”)).
E.
Throughout this document the asset being valued is referred to as the “subject intangible asset” and other assets in the group of
assets that also contribute to the group’s earnings as “contributory assets.”
F.
From a historical perspective, the so called “formula approach” of the U.S. Internal Revenue Service’s Revenue Ruling 68-609, 1968-
2 C.B. 327 and the earlier ARM 34 are often referred to as the Excess Earnings Method and are different from the MPEEM, although
the MPEEM has its roots in this literature.
G.
It should be noted that other methods (aside from the MPEEM) exist for the valuation of intangible assets, and this document does
not purport to recommend the use of a specific method for a specific asset.
1.11 This document discusses the definition and identification of contributory assets, calculation of CACs, and considerations when selecting
appropriate rates of return on, and, in some cases, return of, those contributory assets in the application of the MPEEM.
6
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2.0 Identification of Contributory Assets
2.1 What Constitutes a Contributory Asset
2.1.01 Contributory assets are defined as assets that are used in conjunction with the subject intangible asset in the realization of prospective
cash flows associated with the subject intangible asset. Assets that do not contribute to the prospective cash flows associated with the subject
intangible asset are not contributory assets. For example, a certain amount of real property (land and buildings) may be necessary to support
the cash flow attributable to a subject intangible asset. Alternatively, land held by an entity for investment (a non-operating asset) would not
be appropriate to include as a contributory asset if the land is not necessary for, or expected to contribute to, the generation of the prospective
cash flows of the subject intangible asset.
2.1.02 The valuation of the subject intangible asset needs to reflect those assets that market participants would treat as contributory assets,
regardless of whether an entity has acquired them in a transaction, already owns them, or would need to purchase them.
2.2
Contributory Assets
2.2.01 The types of asset categories required to support the cash flows associated with a subject intangible asset are based on the facts and
circumstances of the entity and the subject intangible asset. The asset categories and examples of their components that might be considered
as contributory assets are illustrated in the following table:
Asset Category
Illustrative Components
Working Capital2
Fixed (Tangible) Assets
Cash, Receivables, Inventory, Payables, Accruals
Real Property, Machinery and Equipment, Furniture and Fixtures
Intangible Assets
Trademarks and Trade Names, Technology, Software, Customer Relationships, Non-Compete
Agreements, Assembled Workforce3
23
2.2.02 The assumptions used in arriving at the fair value of the subject intangible asset should reflect those assumptions that market
participants would use in pricing the subject intangible asset or the group of assets that includes the subject intangible asset. Therefore, the
PFI should consider market participant assumptions regarding levels of required contributory assets, either on an individual or grouped basis,
as appropriate.
2 Working Capital for purposes of this document specifically excludes excess cash above normal operating levels and all interest bearing debt and is often referred to in
practice as “Debt Free Net Working Capital” or “Net Working Capital.”
3 This list is not all inclusive. FASB ASC paragraphs 805-20-55-2 through 805-20-55-45 (formerly Paragraphs A29 through A56 of the Financial Accounting Standards
Board, Financial Accounting Series, “Statement of Financial Accounting Standards No. 141 (Revised 2007) – Business Combinations”) provide a more detailed list of
potential intangible assets. Industry-specific assets also may exist in specialized circumstances.
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7
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
2.2.03 The PFI should include normalized4 levels of required contributory assets reflective of the market participants’ view of the entity’s
position in its life cycle. For example, a normalized level of fixed assets for an entity in its infancy may be different from the level required
once the entity reaches a mature stage in its life cycle. To the extent the PFI reflects excess or deficient levels of contributory assets, it should
be adjusted to reflect normalized levels.
2.2.04 Working Capital
2.2.05 Working capital is a necessary element of an entity required to support the operations. Working capital, including, for example,
operating cash, receivables, inventory, payables, accruals, and other short-term assets and liabilities, is continually needed by the entity and
is constantly turning over to maintain the required level without a loss in value due to economic depreciation. As such, it is assumed to be an
asset that does not deteriorate in value.
2.2.06 The appropriate level of working capital to use as a contributory asset is a normalized level of working capital. A normalized level
of working capital would represent only those working capital items and amounts necessary for market participants to support the operations
of the entity, or in the case of valuing a subject intangible asset, those working capital items that would support the generation of cash flow
associated with the subject intangible asset.
2.2.07 If an entity has deferred revenue, this liability may or may not be included as a component of the working capital that is then used as
the basis for a CAC. Whether to include or exclude the deferred revenue as a component of the working capital will depend on how the PFI was
developed. If the revenue component of the PFI was developed on an accrual basis, then it likely would be appropriate to include the deferred
revenue as a component of working capital. The Working Group believes that deferred revenue should be included in working capital on a
normalized basis if deferred revenue is a part of an entity’s ongoing operation. The Working Group also believes that, in such a circumstance,
the level of accrued deferred revenue included in net working capital for purposes of calculating the CAC should reflect an entity’s ongoing
operations and be consistent with the PFI, as opposed to a level reflecting a “one-time” adjustment5 to the fair value of any legal performance
obligation that would arise in a business combination accounting setting.
2.2.08 Fixed Assets
2.2.09 Fixed assets are needed primarily to enable the productive capability of an entity. These assets may include land, land improvements,
buildings, machinery, furniture, fixtures and equipment, leasehold improvements, and natural resources, for example. Fixed assets frequently
are assets that deteriorate and require replenishment/replacement to sustain the productive capability of the entity.
4 Normalized, as used in this document, refers to assumptions that are consistent with the entity or subject intangible asset from a market participant perspective. For ex-
ample, if it is observed that the PFI includes excess (or deficient) levels of an asset, a normalized level of the asset would include adjustments to reflect the level needed
to operate, and would exclude the impact of the excess (or deficient) level from a market participant perspective. This use of the term “normalized” is different from the
normalization adjustments that may be applied in a business valuation when adjusting financial data to remove the effect of nonrecurring or unusual items.
5 See, for instance, the discussion of “one-time” adjustments in paragraph 3.2.03.
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2.2.10 The stage of an entity in its life cycle may influence the level of fixed assets necessary for operations at a given point in time.
For example, the fixed asset levels of an early stage entity may not be representative of the fixed asset levels required for mass product
commercialization. An estimate of a normalized level for market participants would be necessary when calculating the CAC. This normalized
level should represent the amount that market participants would consider appropriate to support the subject intangible asset.
2.2.11 If the fixed assets in place for an acquired entity (or other subject entity) as of the valuation date do not represent the level of fixed
assets necessary to generate the prospective cash flow stream, then it would be appropriate to use an estimated level of those necessary fixed
assets based on market participant assumptions. This normalized level of fixed assets should be measured at fair value and should be reflected
in the PFI.
2.2.12 Intangible Assets
2.2.13 Intangible assets that meet the recognition criteria under FASB ASC Topic 805 (formerly FASB Statement of Financial Accounting
Standards No. 141 (Revised 2007) (“FASB Statement No. 141(R)”), as being either legal/contractual or separable represent contributory assets
if their use contributes to an aggregate economic earnings stream associated with the subject intangible asset. FASB ASC paragraphs 805-20-
55-2 through 805-20-55-45 (formerly paragraphs A29 through A56 of FASB Statement No. 141(R)) provide additional guidance regarding,
and examples of, intangible assets that meet the criteria for recognition as an asset apart from goodwill. Intangible assets identified in FASB
ASC Topic 805 include marketing-related intangible assets, customer-related intangible assets, artistic-related intangible assets, contract-based
intangible assets, and technology-based intangible assets. Valuation specialists should first consider whether the revenue or profits can be split
to allocate the economic earnings stream among intangible assets. The use of a royalty savings method is viewed as a form of profit split in the
context of this document. Absent the ability to make such a division, the use of a CAC is the best method for compensating for the contributory
asset’s contribution to the aggregate economic earnings steam associated with the subject intangible asset.
2.2.14 Additionally, other reliably measureable intangible assets (or elements of an entity) that do not meet the criteria under FASB ASC Topic
805 for recognition separate from goodwill, such as an assembled workforce, would be considered as contributory assets if they contribute to
the generation of the cash flow stream associated with the subject intangible asset. An assembled workforce is one example of an element of
goodwill that generally is recognized as a contributory asset although it is not recognized on the balance sheet apart from goodwill under FASB
ASC Topic 805.
2.2.15 The determination of whether a CAC for elements of goodwill is appropriate should be based on an assessment of the relevant facts
and circumstances of the situation, and the valuation specialist should be cautioned to not mechanically apply CACs or alternative adjustments
for elements of goodwill if the circumstances do not warrant such a charge. The Working Group believes that assembled workforce is typically
the only element of goodwill for which a CAC is taken. Accordingly, the burden of proof is higher to support taking CACs or making alternative
adjustments for elements of goodwill other than assembled workforce.
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BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
2.2.16 If other elements of goodwill are significant contributors to the stream of economic earnings associated with the subject intangible asset,
the Working Group believes that the valuation specialist should a) seek to identify and estimate the fair value of those elements (when reliably
measurable) for use in calculating CACs, b) make an alternative adjustment to the economic earnings stream in order to compensate for the
contribution of the other element or elements of goodwill, or c) consider another method (e.g. the Greenfield method) that more accurately
isolates the economic earnings stream attributable solely to the subject intangible asset.
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3.0 Valuation Methodologies and the Application of Contributory Asset Charges
3.1 Introduction and General Concepts
3.1.01 All valuation methodologies applied in the valuation of any asset may be broadly classified into the cost, market, or income approaches.
In a valuation study, all three would be considered (for application), and the approach or approaches deemed most appropriate would then
be selected as the proper approach(es) to use in the valuation of that asset. The valuation of intangible assets is most commonly conducted
using an income approach in which there is an identifiable stream of cash flows associated with that intangible asset. Typical income approach
methods used in the valuation of intangible assets include the relief from royalty method, the MPEEM, and a number of other methods. The
MPEEM is commonly employed in the valuation of certain technology (existing or in development), customer relationships, and many other
assets.
3.1.02 Prior to application of the MPEEM, the valuation specialist should ensure that the PFI estimates are representative of the views of
market participants. Inclusion of the effects of entity-specific synergies should be avoided, while market participant synergies are appropriate
for inclusion in the PFI.
3.1.03 The MPEEM requires PFI estimates of cash inflows and cash outflows, combined with charges for returns on, and where applicable,
returns of tangible and intangible assets employed in the generation of cash flows associated with the subject intangible asset (including
elements of goodwill such as the assembled workforce).
3.1.04 Cash inflows are primarily represented by revenue. It is important to note that, in the application of the income approach to value a
subject intangible asset, the valuation specialist should properly identify the correct stream of revenue associated with the subject intangible
asset. For some intangible assets, this stream of revenue may be the same as the revenue estimates for the entire entity, while for other
intangible assets the valuation specialist may identify a portion of this total revenue.
3.1.05 Cash outflows associated with the subject intangible asset might include direct and indirect expenses for costs to complete (in the case of
in-process research and development (“IPR&D”)), manufacturing, sales, marketing, routine technical maintenance, general and administrative
expense, and taxes, for example.
3.1.06 The contributory assets reflected in the MPEEM should include all assets required by market participants to realize the cash flows
associated with the subject intangible asset. An acquired or acquiring entity may already have access to some of these assets, or the acquiring
entity may need to gain access to them in some other way if they are necessary to generate the prospective cash flows in the aggregate. The
CACs should be based on the fair value of the required market participant levels of contributory assets. These charges generally represent a
return on and, in some cases, a return of these contributory assets based on the fair value of such contributory assets.
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BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
3.1.07 In practice, for certain classes of assets (for instance, working capital and fixed assets) book value is often used as a proxy for the fair
value on which to calculate CACs. The Working Group believes that the use of book value as a practical expedient for measuring fair value
can be appropriate based on facts and circumstances so long as the use of book value is consistent with the fair value measurement objective
as it is applied to the subject intangible asset. Further, market participant views of the levels of contributory assets for the subject entity are
often estimated in practice with reference to industry comparable data, which is often only available based on book value. The Working Group
believes that valuation specialists should exercise caution, however, because the concept remains that the book value of contributory assets may
only be utilized when they are not believed to be significantly different from fair values.
3.1.08 The Working Group believes that the fair value of an asset should not differ depending on the tax structure of a particular transaction.6
Market prices of fixed assets reflect the tax benefit of depreciation. Similarly, if an intangible asset were to be sold (either as a single asset or
as part of a group of assets, depending on highest and best use), the purchase price would reasonably reflect the benefit of amortizing the asset
for tax purposes. For this reason, the fair value of an intangible asset includes the benefit of the tax amortization when applying an income
approach. Therefore, CACs on contributory assets should be based on the fair value of these assets including their tax depreciation benefit
or tax amortization benefit (“TAB”). (It is not within the scope of this document to address whether application of the cost approach to value
intangible assets should be on a pre-tax or after-tax basis. For examples in this document, pre-tax costs are used because the Working Group
has observed this to be the most prevalent method. If a pre-tax cost is used, the addition of a TAB is not commonly considered appropriate,
whereas the addition of a TAB is commonly considered appropriate with an after-tax cost.7 If an after-tax method with the TAB is used in an
analysis, adjustments would be necessary for consistency of assumptions.)
3.1.09 Careful analysis is necessary to determine which assets or elements of an entity contribute to a subject intangible asset. In some
cases, a determination can be made to exclude (as contributory) assets that are not required by the subject intangible asset. Many assets are
contributory to all subject intangible assets. In this circumstance, the CAC earned by a contributory asset should be allocated to each subject
intangible asset using a method that appropriately reflects its utilization. For example, a subject intangible asset that uses twice as much of
a contributory asset as another subject intangible asset should incur twice the CAC. When objective information is available, it forms the basis
of a CAC allocation. In the absence of reliable data, a reasonable assumption should be used. The most common method to allocate CACs to
assets generally is based on the relative revenue generated by each subject intangible asset each year. There may be instances, however, when
other methods such as relative amounts earned, relative units produced, relative square footage occupied, relative headcount used or relative
costs expended by each subject intangible asset, each year, may represent a more appropriate allocation method. When a contributory asset
is not expected to contribute to a particular subject intangible asset, its return is not charged against that subject intangible asset. (Its return is,
however, charged against all of the future or current intangible assets to which it does make a contribution.)
3.1.10 Following identification of the cash inflows and outflows associated with the subject intangible asset and the reflection of CACs, the
remaining net cash flows (or multi-period excess earnings) are attributed to the subject intangible asset and, when discounted to present value,
provide an estimate of the subject intangible asset’s value (prior to application of the tax amortization benefit). (See, for example, FASB ASC
paragraphs 820-10-35-32 and 820-10-35-33 (formerly paragraph 18b of FASB Statement No. 157) and paragraph 2.1.10 of the 2001
6 The discussion here and elsewhere assumes the tax benefits of depreciation and intangible asset amortization are available to market participants.
7 This parenthetical is addressing the cost approach, not a cost-savings method that is an income approach.
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AICPA Practice Aid Series: “Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software,
Electronic Devices and Pharmaceutical Industries” (“IPR&D Practice Aid”).)
3.1.11 The Working Group believes that valuation specialists should take special care when application of the MPEEM results in an individual
year’s excess earnings being negative or indicates a negative value in the aggregate solely as a result of the application of CACs. The valuation
specialist should perform additional review of the calculations to ensure the integrity of the inputs and the structure of the analysis. In some
cases, a negative value in the aggregate may indicate that there is no economic basis for recognizing the asset (e.g. a negatively valued
customer relationship). In other cases, a negative value for an asset within a portfolio of assets may need to be offset against positive values
of the remaining assets within the portfolio or recognized as a distinct liability (e.g. a single contract within a group of contracts, if appropriate
from an accounting perspective). Further, a negative excess earnings amount for a given year within a projection period associated with a
subject intangible asset should not be disregarded in measuring the fair value of that asset.
3.1.12 The Working Group believes that issues such as those discussed in Section 3.1.01 through 3.1.11 demonstrate the complexity of
applying the MPEEM and the care that should be taken by valuation specialists in estimating fair value utilizing this method. An important
attribute of this method is that it provides the ability to reconcile to the entity value and demonstrates that the calculation of the CAC does not
create or destroy aggregate asset value. The application of CACs is essentially an attribution of earnings to the contributory assets.
3.2 Working Capital
3.2.01 In considering the appropriate CAC for working capital, it should first be noted that increases or decreases in required working capital
would not be included as a charge or benefit to the cash flow because growth investments (or “dis-investments”) are accounted for through
increases or decreases in the CAC. It should be noted that individual components of working capital (e.g. accounts receivable and inventories)
may be subject to write-downs from time to time. Such decreases in value are charged through the income statement, and recurring expense
assumptions would encompass future expectations regarding write-downs. Thus, it is appropriate to charge the subject intangible asset only
with an appropriate return on working capital that is based on the required level of working capital for each period. In other words, the return
on working capital represents the charge for utilization of working capital by the subject intangible asset. When the working capital is no longer
required (e.g. at the end of the economic life of the subject intangible asset) it can be used by other assets. One common method of calculating
the period-specific working capital CAC would be based on the required return on total working capital as a percentage of total revenue with that
percentage then applied to the specific revenue associated with the subject intangible asset. See Exhibit A-4 in Appendix A for an illustrative
example of how to calculate a CAC for working capital on an annual basis (the Comprehensive Example). See also Appendix B for an illustrative
example of a practical expedient in the calculation of a working capital CAC (the Practical Expedient).
3.2.02 One issue that arises in certain industry sectors is the appropriate treatment of negative working capital. This does not refer to those
circumstances where inadequate working capital has been acquired as part of a transaction. Instead this is the circumstance in certain industry
sectors for which negative net working capital is the norm. It is the view of the Working Group that negative working capital that is generated in
the normal course of business in certain industry sectors enhances overall entity value and should be considered in determining the appropriate
level of working capital to serve as the basis for calculating CACs. This will, in effect, create “negative” CACs for working capital, the apportioned
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BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
amount of which would enhance the value of the subject intangible asset. This treatment is appropriate because it reflects the economic realities
in those industry sectors and is consistent with the cash flow benefit reflected in the PFI.
3.2.03 Another issue is the impact of one-time business combination accounting adjustments to working capital such as inventory step-ups.
The Working Group believes that such one-time adjustments should be excluded from the initial and ongoing levels of working capital (based
on market participant assumptions) used in the CAC calculation. This view is based on the belief that whether a subject intangible asset is being
valued as part of a business combination or for other purposes it would be valued the same. The inclusion of one-time business combination
accounting adjustments may cause the subject intangible asset to be valued differently for different purposes and, further, is not representative
of the long term need for working capital. The Working Group believes that valuation specialists should not only exclude one-time adjustments
from market participant levels of working capital used in the CAC calculation, but should also make sure to adjust for the effects of any one-time
modifications of the PFI utilized in the valuation of the subject intangible asset to avoid double counting profit or expense. More specifically,
the profit included in the inventory step-up (if applied) would need to be removed from the PFI of the subject intangible asset so that the profit
is not recognized more than once.
3.3 Land
3.3.01 The CAC calculation associated with land is different from that associated with other fixed assets that deteriorate in value over time
and exhibits similarities to the CAC calculation for working capital. Land is not assumed to deteriorate in value over time. Special consideration
should be given to the appropriate market participant level of land and its associated fair value serving as the basis for the calculation of the
CAC, as land values, over time, may move independently from the value of the entity or of the subject intangible asset. The CAC should be based
on the fair value of land necessary to support the earnings associated with the subject intangible asset at any time.
3.4 Fixed Assets (Not Including Land)
3.4.01 The Working Group is aware of many techniques for calculating CACs for fixed assets that are currently in use. This Section 3.4 and the
Comprehensive Example present the two techniques that are believed to be the most common in the profession (in a comprehensive application).
The Working Group understands these detailed calculations often are not necessary and that more simplified versions are often appropriate
(please see the Practical Expedient, Appendix B). Both techniques assume that fixed assets other than land deteriorate in value and, as a result,
the associated CAC needs to incorporate aspects of both returns of and returns on these assets. In addition, the Working Group believes that each
technique should yield approximately the same aggregate CAC as it relates to the subject intangible asset when applied consistently. Finally, the
Working Group has set forth these calculations assuming CACs are applied on an after-tax basis. Pre-tax presentations of these techniques should
be considered equally acceptable presuming the appropriate adjustments to a pre-tax basis of presentation have been made.
3.4.02 The intent of applying a CAC is to provide a charge for the use of the appropriate level of fixed assets required to generate the revenue
and earnings necessary to support the subject intangible asset in each year of the subject intangible asset’s projection period. Acquired (or
initial/current) fixed assets and future capital expenditures represent investments and cash charges at specific points in time. These investments
in fixed assets have utility beyond the period of the cash charge as reflected by the capitalization and depreciation of these investments. CACs
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capture this future utility by replacing the cash charges with a series of charges over the economic life of the fixed asset, as represented by
the required returns of and returns on the fair value of the necessary level of fixed assets. The present value of the series of charges in the
aggregate should be equivalent to the investment such that no value is created or destroyed in the context of the entity as a whole.
3.4.03 Tax or accounting depreciation can be used in these techniques. In this document and the Comprehensive Example, tax depreciation
has been used. Use of accounting depreciation as an option is addressed in the Practical Expedient. Care should be taken to make sure that
all assumptions are consistent, whichever approach is used. Tax depreciation is a non-cash expense that decreases taxable income. As tax
depreciation is added back to after-tax income to arrive at free cash flow, the net effect is to reflect the benefit of tax depreciation embedded
in the fixed assets. Tax-effecting EBITDA has the impact of increasing taxes and removing the benefit of tax depreciation of the fixed assets.
Alternatively, tax-effecting EBIT and adding back tax depreciation retains the benefit of tax depreciation in the projections. Although the
Working Group is aware of techniques that tax-effect EBITDA, the calculations shown in the Comprehensive Example in Appendix A use tax-
effected EBIT. By doing so, the benefit of tax depreciation, which is already reflected in the fair value of the fixed assets, is not double counted.
3.4.04 It is important to note that both Technique A and Technique B below rely on future estimates of fixed asset fair value balances. The
valuation specialist should be careful to consider whether growth in fixed assets is required to achieve the estimates of future cash flows for
the subject intangible asset as well as the entity and whether this growth occurs at the same rate as revenue growth or at a different rate. This
consideration can be magnified by changes in fixed asset turnover for the entity as a whole, and reduced requirements for fixed assets at an
individual subject intangible asset level.
3.4.05 A general description of the detailed version of each of the two most common techniques currently in practice is presented below. For
purposes of this Monograph, the term “economic depreciation” is used to indicate the aggregate decline in value that occurs over the economic
life of the asset. This term is used here in order to differentiate this concept from tax or accounting depreciation.8
3.4.06 Technique A: “Average Annual Balance”
3.4.07 The CAC is calculated based on two separate charges for the return of and return on the fair value of the fixed assets in each year of the
projection. The return of for each year is equivalent to the sum of: a) annual economic depreciation for the fair value of the acquired or current
fixed assets (adjusted to market participant levels) and b) annual economic depreciation for the projected market participant levels of capital
expenditures required to support the entity’s operations and the subject intangible asset over that asset’s remaining useful life. The return on
is derived by applying an appropriate after-tax rate of return consistent with the risk of an investment in the fixed assets. The returns on are
calculated for each year of the projection based on the average balance of the required future estimated fixed assets at market participant
levels. Typically, CACs for both the returns of and returns on are first calculated in aggregate for the entity and are then allocated across assets
to which they contribute (based on a method such as relative annual revenue, discussed above). CACs are deductions that exclude capital
expenditures (because the capital expenditures are replaced by and incorporated in the CAC for the fixed assets). The CACs are incorporated
in the MPEEM in any given year as follows:
8 The Working Group realizes that this use of the term is contrary to its common use regarding the factors of depreciation of tangible assets, which are described as
including physical, functional, and economic obsolescence factors.
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BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
EBITDA
Less: Tax depreciation
EBIT (amortization assumed to be zero)
Less: Taxes
Debt free net income
Add: Tax depreciation
Less: Return of the fixed assets (economic depreciation of fair value)
Less: Return on the average balance of the fixed assets (at fair value)
Less: Other CACs (as necessary)
Equals: Excess earnings or cash flow
3.4.08 See Exhibit A-5 in Appendix A for an illustrative example of how to calculate a CAC for fixed assets using the average annual balance
technique.
3.4.09 Deducting tax depreciation expense in calculating EBIT does not necessarily represent the return of the fixed asset investment because
tax depreciation is not necessarily equivalent to economic depreciation in a given year. The Working Group recognizes that the sum of tax
depreciation charges over the life of the fixed asset will be equivalent to the sum of the economic depreciation charges over the life of the fixed
asset, presuming the tax basis of the fixed asset resets to fair value as of the date of valuation. The only difference would be that of timing. In
practice, the return of the fixed assets is often assumed to be equivalent to the annual tax or accounting depreciation and is netted against the
add back of depreciation and the CACs presented are thus limited to the return on the fixed assets. The Working Group recognizes that such a
simplification may have an insignificant effect on the calculation of the fair value of a subject intangible asset, particularly when fixed assets
represent a relatively insignificant proportion of the economic balance sheet of the entity.
3.4.10 Technique B: “Level Payment”
3.4.11 CACs are combined into one charge that takes into account both return of and return on the fair value of fixed assets. The principle
behind this technique is that, in the application of the MPEEM, the cash flows associated with the subject intangible asset would need to be
assessed a series of level annual payments for the use of the fixed assets required to produce the cash flows associated with the subject
intangible asset. The level payment CAC calculation is applied to both the fair value of the acquired or current fixed assets and projected capital
expenditures (adjusted to market participant levels). Just as in Technique A, the concept is that the required current and future fair values of
fixed assets at market participant levels should serve as the basis for each year’s CAC. Similar to Technique A, a CAC representing both the
returns of and returns on is first calculated in aggregate and then applied in a prorated manner (such as that based on a percentage of revenue)
to the revenues of the subject intangible asset. In Technique B, the CAC typically is calculated as a series of level annual payments based on
a constant after-tax rate of return consistent with the risk for an investment in the fixed assets. Such payments can be calculated discretely
for the acquired or current fixed assets and each projected annual capital expenditure (referred to herein as a “waterfall payment”) or some
variation thereof that incorporates the annual beginning balance of the fixed assets and a weighted remaining useful life of each respective
balance. The most precise manner to determine the CAC is to calculate an amount for each equivalent remaining useful life (“RUL”) asset group
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(waterfall payment) for the acquired or current fixed assets and capital expenditures. Preparing calculations at this level results in outcomes
that are essentially equivalent to those from Technique A. The CACs are incorporated in the MPEEM, in any given year, as follows:
EBITDA
Less: Tax depreciation
EBIT (amortization assumed to be zero)
Less: Taxes
Debt free net income
Add: Tax depreciation
Less: Level Payment CAC (return of and on the fixed assets, at fair value)
Less: Other CACs (as necessary)
Equals: Excess earnings or cash flow
3.4.12 See Exhibit A-6 in Appendix A for an illustrative example of how to calculate a CAC for fixed assets using the level payment technique.
3.4.13 Both techniques allow for the alignment of the entity value analysis with the asset fair values and demonstrate that the calculation of
the CAC does not create or destroy aggregate asset value. The application of CACs is essentially an allocation of earnings to the contributory
assets and, as such, should result in approximately the same aggregate earnings and asset values.
3.4.14 The Working Group is aware that certain practical expedients to both Technique A and Technique B have been used in practice. For
instance, techniques have been observed that incorporate “smoothing” the annual CAC for fixed assets (and often for other asset categories
as well), to a fixed percentage of revenue, which combines both the calculation of the CAC, and the allocation (on a relative revenue basis) of
the CAC to subject intangible assets into a single factor. Another variant of such techniques aggregates fixed assets into a single pool, rather
than treating them as discrete “vintages” based on year of acquisition as is the case in both Technique A and Technique B. The Working Group
recognizes that the use of such techniques may have an insignificant effect on the calculation of the fair value of a subject intangible asset,
particularly when fixed assets represent a relatively insignificant proportion of the economic balance sheet of the entity. See Appendix B
(Practical Expedient) for an illustrative example of calculating a CAC for fixed assets using a “smoothing” technique.
3.4.15 The Working Group believes that valuation specialists should be cautious in deciding whether to apply such practical expedients when
fixed assets represent a significant proportion of an entity’s economic balance sheet. Also, such calculations are particularly sensitive to RUL
assumptions when aggregating fixed assets into a single pool rather than treating them as discrete “vintages” based on year of acquisition.
Conceptually, the remaining life of a pool of fixed assets in a given year should be calculated as the weighted average of the RUL’s of each
“vintage.” This assumption will likely vary from year to year, as existing fixed assets age, and new fixed assets are acquired. Precise estimates
of an aggregate RUL are best extracted from applying either Technique A or Technique B, which would tend to counteract the time saving benefit
of applying a practical expedient of this kind. Nonetheless, estimates of an aggregate annual RUL for a pool of fixed assets may be sufficient
when the fixed asset balance is a relatively insignificant portion of the entity’s economic balance sheet.
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3.4.16 While the Working Group has applied these techniques on an after-tax basis in the example calculations, some believe that pre-tax
calculations would more closely emulate an actual circumstance of renting or leasing assets, as rental or lease payments are deductible on a pre-
tax basis. It is the Working Group’s view that it does not matter whether these calculations are performed on a pre-tax or after-tax basis (since
they are essentially subsets of the same methodologies) as long as the appropriate adjustments are made such that resulting value estimates
are consistent, and value is neither created nor destroyed as a result of the technique selected. Terms such as “gross lease” or “gross rent”
have been used to describe such pre-tax calculations. A sample “gross lease” calculation has been included in the Toolkit associated with this
Monograph (see Foreword for additional description of the Toolkit). The Working Group has observed that CAC calculations are more commonly
applied in practice on an after-tax basis and as a result has chosen an after-tax presentation as part of this Monograph.
3.5 Identified Intangible Assets and Contributory Elements of Goodwill (Including Assembled Workforce)
3.5.01 In calculating the CAC associated with contributory intangible assets, it is often assumed that the costs to maintain the value of a
particular contributory intangible asset are considered a period expense (e.g., recruiting and training to replace people that leave and thereby
maintain workforce value, sales and marketing expense to maintain customer relationship value when customer relationships are valued by a
method other than MPEEM), and therefore these costs serve as a proxy for return of the investment in existing and future assets. While it may
be theoretically correct to add back all expenses related to the maintenance of the contributory intangible assets to pre-tax cash flow and then
take a true return of for a particular contributory intangible asset, there may be difficulty in estimating supportable costs to be added back.
Expenses in the nature of identifiable growth investments might be an exception. Significant identifiable growth investments are analogous
to incremental working capital and capital expenditures in excess of depreciation and should not be deducted (see Section 3.7 regarding
assembled workforce).
3.5.02 It is the view of the Working Group that the common practice of assuming that costs to maintain and enhance intangible assets are part
of the expense structure of the entity’s business is an appropriate simplifying assumption (subject to the potential exception discussed above).
Attempts to separate out expenses associated with maintaining or enhancing intangible assets, coupled with calculating an appropriate return of
for a particular contributory intangible asset might be difficult in practice, because of the inherent challenge in isolating expenses that accurately
match an appropriate return of. This common practice, however, should be supplemented by market participant research into appropriate
expense levels for the aggregate entity and for the subject intangible asset to further support the use of the expense structure of the entity/
asset as a proxy for return of, when practical. Also, for entities that have grown through acquisition, valuation specialists should remove any
amortization expense related to contributory intangible assets that could, in effect, “double count” the proxy for return of. Valuation specialists
should be cautioned that, in instances where the fair value of a contributory intangible asset is significantly different from a stream of foregone
expenses, the use of the expense structure of an entity may not match an appropriate return of the fair value of the contributory intangible
asset. The Working Group believes that in such an instance, an add back of expenses together with an appropriate calculation of the return of,
based on fair value, would more accurately reflect the CAC associated with the contributory intangible asset.
3.5.03 The Working Group believes that an alternative approach to CACs for contributory intangible assets should be used when the contributory
asset has been valued using a relief from royalty method. The relief from royalty method involves the estimation of an amount of hypothetical
royalty savings enjoyed by the entity that owns the intangible asset because that entity is relieved from having to license that intangible asset
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from another owner. This same royalty rate should be used as a pre-tax charge in the calculation of earnings of the subject intangible asset
because the use of a royalty savings method is viewed by the Working Group as a form of profit split. (Alternatively, the royalty rate could be
converted to an after-tax rate and shown as an after-tax charge in the calculation of cash flow of the subject intangible asset, which would be
a mathematically equivalent treatment.) A royalty rate should be analyzed to determine whether it compensates the licensor for all functions
(ownership rights and responsibilities) associated with the asset. Such an analysis would include consideration of expenses recognized by the
licensee versus expenses otherwise considered to be the responsibility of the licensor. A royalty rate that is “gross” would consider all functions
associated with ownership of a licensed asset to reside with the licensor while a royalty rate that is “net” would consider some or all functions
associated with the licensed asset to reside with the licensee.
3.5.04 The Working Group recognizes that there has been diversity in practice as to whether multiple subject intangible assets (which share
the same revenue/cash flows) should be valued using an MPEEM and, if so, whether such analyses should reflect simultaneous cross charges
between subject intangible assets. For example, both customer-related assets and technology assets have been observed in practice as being
valued using this method with such cross charges reflecting an attempt to adjust for overlapping revenues/cash flows.
3.5.05 The Working Group strongly believes that the use of simultaneous application of the MPEEM with either single or multiple cross charges
to multiple intangible assets that share the same revenue/cash flow is not best practice and should be avoided.
3.5.06 One alternative, when possible and supportable, for avoiding overlapping revenues/cash flows would be to “revenue/cash flow split”
the PFI related to the multiple subject intangible assets such that their analyses are mutually exclusive. In such a case no one subject intangible
asset should be charged for any other which has been subject to the revenue/cash flow split. Valuation specialists should be cautioned, however,
against the use of arbitrary means by which they split revenues or cash flows. Thus, in performing a revenue or cash flow split, the valuation
specialist may give consideration to factors such as the following as support for the split (this list is not intended to be exhaustive):
•
•
•
•
•
a clearly delineated revenue split between assets,
a rate of return analysis on marketing expenses versus research and development expenses,
a projected revenue pattern associated with different generations of a product,
the migration of relative product contributions between assets, or
the relative contribution of core or base technologies as compared to applied technologies.
3.5.07 Another alternative is to value only one subject intangible asset using the MPEEM while any other subject intangible asset would be
valued using an alternate method. Examples of these alternate methods are relief from royalty, cost approach, “with and without,” and
techniques that indicate a “synthetic” or “hypothetical” royalty (in which a portion of the earnings are identified that essentially represent a
royalty payment, but without the use of royalty rate market data9). In this case, the asset valued using the MPEEM would be charged a royalty
as described above for the other asset(s) to the extent that the other asset(s) is (are) contributory or to the extent that the other asset’s (assets’)
value(s) is (are) derived from overlapping revenues/cash flows.
9 These techniques might include, among others, what has been referred to as a “quadrant” or “separation” technique, as discussed in Horvath, James L. and David W.
Chodikoff. 2008. Taxation and Valuation of Technology: Theory, Practice, and the Law, and the subject of a recent presentation by Squires, Renton C., “Dual Primary
Asset Valuation,” Presentation at the American Society of Appraisers’ Advanced Business Valuation Conference, Boston, October 20, 2009.
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BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
3.6 Contributory Asset Charges in Future Periods (or Over Time)
3.6.01 The MPEEM, as a form of the income approach, relies on the PFI associated with the subject intangible asset. It is important that the
valuation specialist understand that the composition of assets that generate cash flow associated with the PFI will change over time. For
instance, fixed assets, technology and customer relationships that existed as of the valuation date will contribute a lesser amount to the PFI
over time as these assets decay economically and are replaced by future assets. Therefore, the rate of replacement is a key assumption for
the valuation specialist to consider. Further, the relative importance of the various types of assets (e.g. marketing vs. technology intangibles)
may change over time impacting their relative contribution of earnings to the asset group’s PFI in future periods. Valuation specialists should
consider the contributions to cash flow of the various contributory assets (on a market participant basis) and charges for these assets should
be estimated for each year in the projection period, rather than, for instance, automatically fixing such levels to amounts estimated at the
valuation date. The Working Group does note that estimating the appropriate market participant level of contributory assets is highly dependent
on facts and circumstances.
3.6.02 In calculating a CAC, the valuation specialist should consider whether each of the contributory assets used in the previous period CAC
calculation remains relevant in the next period. There is diversity in practice as to what period CACs should be calculated when considering
current versus future levels of intangible asset investment. It is the Working Group’s position that, generally, CACs for the contributory
intangible assets should be applied throughout the life of the subject intangible asset. This view is based on the premise that while the specific
contributory intangible asset on hand as of the valuation date may diminish over time, it will be supported, maintained, enhanced and/or
replaced and, therefore, future levels of the contributory intangible asset will be present to contribute to the generation of cash flows. If a
contributory intangible asset would not be maintained or replaced upon expiration, for example, in the case of a non-compete agreement
arising from a transaction between a buyer and seller, the CAC would only be applied through the economic life of the contributory asset. Key
to determining whether it is appropriate to continue to take a CAC on a particular asset or asset category is whether that type of asset continues
to be necessary to support the earnings associated with the subject intangible asset.
3.6.03 The migration of the utilization of a contributory asset should not be confused with the economic deterioration in value of a contributory
asset that was in place as of the valuation date. It may be assumed that the economic contribution of a certain type of contributory asset is
maintained over the life of the subject intangible asset through investments to create the next generation(s) of the contributory asset. For
example, an MPEEM analysis valuing customer relationships that shows no CACs for technology (that has been valued using a cost approach,
for example) beyond the economic life of the existing developed technology overlooks the circumstance that new technology will most likely be
developed and would be necessary to support the ongoing customer relationships. Note that, in such cases, the investment in creating the new
technology beyond replacement of the existing technology (a growth investment) may need to be adjusted out to avoid double counting. (See
discussion regarding pre-tax growth investments in Section 3.7.)
3.6.04 The Working Group notes that many contributory assets are valued using the relief from royalty method of the income approach. It is
the Working Group’s belief that if this method has been used to value a contributory asset, the appropriate corresponding method would be
to perform a profit split by deducting a royalty from the cash flows of the subject intangible asset that is consistent with the royalty that was
utilized to value the contributory asset. The valuation specialist should also consider whether the royalty would vary over time. Additionally,
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the valuation specialist should consider whether the derived royalty rate is all-inclusive of the benefits and costs associated with the asset (see
paragraph 3.5.03). If not, further analysis and adjustments may be necessary to reflect an appropriate royalty rate and expense structure.
3.6.05 In cases of business combinations, there may also be instances in which certain assets of the target (acquired) entity are being
abandoned by the acquiring entity (reflective of market participants), but a CAC for that type of asset is still required. For example, the
acquiring entity may plan to abandon the trade name of the acquired entity. However, the trade name of the acquiring entity would then be
substituted in its place. When the abandoned asset is replaced by another asset (such as the acquiring entity’s trade name) and is necessary to
support the asset group’s PFI, a CAC should still be included for this required contributory asset.
3.6.06 It should be noted that, for those situations above, the valuation specialist should also consider whether the contributory asset to be
used or replaced in the future would have an economic return that varies over time. For example, the contribution to the earnings associated
with a subject intangible asset by a particular contributory asset may increase over time. A trademark of an acquired entity being replaced by a
stronger trademark (reflective of market participants) is an example of this situation. In such case, the PFI would need to reflect the potentially
higher earnings caused by the use of a stronger trademark. As another example of such variability, the contribution to earnings by technology
assets may initially be higher for early-stage technologies, but as customer relationships evolve over time, the technology asset’s contribution to
the PFI may decline relative to the contribution by the customer relationship asset. These changes could be reflected as a change in the royalty
rate over time (based on market participant data).
3.6.07 In some circumstances, required levels of contributory assets will scale with revenues. Common examples of these are working capital,
assembled workforce, and fixed assets. In these situations, the valuation specialist should understand if the contributory asset would grow at a
rate equal to the rate of revenue growth or at a rate different from this rate of growth. Reference to market participant metrics such as asset
turnover rate (in the case of working capital and fixed assets) may be helpful to the valuation specialist when making the determination. See
Appendix B, the Practical Expedient, for an illustrative example.
3.6.08 The stage of an entity in its life cycle (as viewed by a market participant) is important as the valuation specialist considers future
contributory asset requirements. In many cases early stage companies may be experiencing rapid growth which allows them to leverage
existing assets more efficiently over time and, as such, the level of contributory assets may decline as a percentage of revenue (in some cases
this declining percentage may be offset through allocation of the aggregate CAC to current and future assets thereby effectively “smoothing”
the CAC allocated to the subject intangible asset over time). Further, mature companies would expect to see relatively stable levels of assets
in comparison to revenue. Finally, companies in decline may have assets that are no longer contributing to the cash flows associated with the
subject intangible asset.
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BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
3.7 Special Adjustments for Growth Investments in Contributory Intangible Assets Valued Using the Cost Approach10
3.7.01 In the PFI for an entity, growth investments in net working capital and fixed assets are shown as “below the line” (after-tax) expenditures.
In the application of the MPEEM, such expenditures are replaced with CACs on the “grown” value of the net working capital or fixed assets
existing in each year of the PFI. Conceptually, the present value of the increment of the CAC relating to the growth investment should equal
the amount of the growth investment.
3.7.02 In contrast, growth investments in the assembled workforce (and in other assets, at times) are pre-tax expenditures. Assuming the
assembled workforce was valued based on pre-tax costs, the CACs on those growth investments are calculated at amounts that assume the
value of the assembled workforce has grown by the same amount as the pre-tax expenditure. When it has a significant effect on the analysis,
the growth investment in the assembled workforce should be differentiated from the maintenance expense, because the maintenance expense
provides for the return of the contributory asset. See Exhibit A-7 in Appendix A for an illustrative example of the calculation of the CAC on the
assembled workforce.
3.7.03 The application of the MPEEM should not create or destroy value when compared to the entity value. In order to a) accomplish this
correct application, b) be consistent with the treatment of net working capital and fixed assets, and c) not double count the “costs” of the
contributory assets in the valuation of a subject intangible asset (such as a customer relationship), it is necessary (when significant) in the
application of the MPEEM to remove (add back) the growth investment in assembled workforce because it is being replaced with a CAC. The
amount added back should be the increase in fair value. Assuming the acquired or current assembled workforce was valued based on pre-tax
cost, the amount added back for the growth investment would be the pre-tax amount.
3.7.04 Although this add-back of the growth investment in assembled workforce is uncommon in current practice, in order to be precise, it is
an adjustment that is required for the fair value of the total assets (net of non interest-bearing current liabilities) to balance with the entity fair
value. The Working Group believes that this adjustment is typically insignificant and therefore unnecessary, but the valuation specialist should
be alert for instances in which it is significant.
3.7.05 A further discussion of why this add-back should be calculated on a pre-tax basis is included in Appendix C.
10 This section also applies to contributory assets valued using any other approach when the expenditure is viewed as a period expense.
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4.0 The Stratification of Rates of Return by Asset or Asset Category
4.1 Introduction
4.1.01 A basic issue in the application of the MPEEM is what rate of return should be earned by each asset category including contributory
assets. The fundamental premise is that the required rate of return should be commensurate with the relative risk associated with investment
in each particular asset. However, there is a paucity of authoritative data on asset-specific returns. Therefore, valuation specialists must rely on
what market evidence is available combined with judgment and tests of reasonableness based on considerations such as likely financing options.
This Section will describe what the Working Group believes to be best practice.
4.1.02 While no specific empirical research or data on asset-specific returns was identified, there is some literature that addresses the topic of
asset returns. One of the earlier and most often cited sources is the Internal Revenue Service (“IRS”) Revenue Ruling 68-609. In this ruling,
the IRS proposed that there is a hierarchy of returns for classes of assets with returns rising as one moves from fixed assets to intangible
assets. Following on this same historical construct, the IPR&D Practice Aid11 noted the expectation that high risk intangible assets, such as
IPR&D projects, would exhibit returns that approached those required by venture capital investors in start-up ventures with the risk declining
as the project neared completion (presuming use of the Discount Rate Adjustment Technique, see paragraph 4.2.08). Other references exist
that relate to this topic.12
4.1.03 One reasonable proxy for risk (and related return) levels for specific assets within an entity is the level of debt financing that could be
secured for that asset. The debt capacity for various classes of assets can vary widely over time based on current economic conditions and the
availability of capital in the credit markets. Valuation specialists should seek information regarding debt capacity that is relevant to the date of
valuation. As an example, Plewa (1985) cites guidelines for general loan to value ratios.13
4.1.04 Using relevant market data, valuation specialists can estimate the market participant cost of equity and cost of debt related to financing
a particular type of asset. From that the valuation specialist can use market-based debt capacity ratios to develop the required return on specific
classes of assets.
11 AICPA Practice Aid Series, “Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software, Electronic Devices and
Pharmaceutical Industries”, 2001, Paragraphs 5.3.87 through 5.3.90.
12 See for example the following articles:
Gooch, Lawrence B., ASA, “Capital Charges and the Valuation of Intangibles” Business Valuation Review March 1992: 5-21.
Asbra, Marc, CFA. “Contributory Asset Charges in the Excess Earnings Method” Valuation Strategies March/April 2007: 4-17.
Stegink, Rudolf, Marc Schauten, and Gijs de Graaff. “The Discount Rate for Discounted Cash Flow Valuations of Intangible Assets” March 2007.
Grabowski, Roger, ASA and Lawrence B. Gooch, ASA, “Advanced Valuation Methods in Mergers & Acquisitions” Mergers & Acquisitions, Summer 1976: 15-29.
Vulpiani, Marco. “Cost of Capital Estimation for Intangibles Valuation in Purchase Price Allocation,” Business Valuation Review, Volume 27, Number 1, Spring, 2008.
13 Plewa, Franklin, Professor of Accounting at Idaho State and George Friedlob, Professor Clemson University, Understanding Cash Flow. 1985.
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BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
4.2 Rate of Return Selection
4.2.01 The concept underlying stratification of rates of return is that the required rate of return on a contributory asset should be estimated
from market derived data reflecting the relative risk of that asset. The intuitive notion is that the perceived relative riskiness of assets reflects
their liquidity/ease of transferability, their ability to be financed by debt or equity, as well as the degree of certainty of realizing future cash
flows from the asset. For certain categories of assets, there are sources of data that can be used as support for the appropriate rate of return,
such as working capital and fixed (tangible) assets (see following paragraphs regarding these asset types).
4.2.02 The risk profile of each asset category should be considered when estimating the appropriate rates of return. While there are exceptions,
the Working Group believes that the risk profile of an entity’s assets generally increases as you move down the balance sheet and, accordingly,
the type of financing available for the assets shifts from debt to equity as the risk profile increases. For example, low risk assets such as working
capital can usually be financed largely with debt and, as such, a short-term borrowing rate such as the prime rate often can be used to estimate
the cost of debt component of the return requirement for this asset. On the other hand, the risk profile of intangible assets is often much higher
and, as such, these assets are typically financed largely with equity.
4.2.03 Selection of an overall rate of return for the entity (the weighted average cost of capital, or WACC) is a necessary starting point prior to
consideration of the stratification of the rates of return. Although it is common that the risk and return associated with the intangible assets of an entity
tend to reflect risk and return levels of the overall entity, valuation specialists should be cautioned that “generic” contributory assets may exhibit costs
of debt and equity that are independent of the entities that own them and would be more specific to the assets themselves. For example, contributory
real estate owned by a high technology entity might not exhibit risk characteristics specific to the high technology industry, but instead would require
equity and debt rates of return specific to real estate investments. Conversely, if the subject working capital or fixed assets are very risky or very
specific to the entity (which may limit the liquidity of the assets due to the lack of a secondary market), the required return on these asset categories
may be higher than otherwise indicated and should be based on the required returns for these types of assets prevalent in the industry.
4.2.04 Once the rates of return for the assets or asset categories are determined, they have three uses in the application of the MPEEM: a)
application of CACs, b) returns on asset categories in the calculation of the weighted average return on assets (“WARA”) (see paragraph 4.3.07),
and c) the discount rate used to derive the present value of the cash flows attributable to the subject intangible asset. Additionally, if a discount
rate is used to value an intangible asset, the Working Group believes that same rate should be used as the rate of return on that asset for CAC
purposes and for calculating the WARA. Valuation specialists should take care to ensure that pre-tax rates have been appropriately adjusted to
after-tax levels for use in computing after-tax CACs. See Section 4.3 for discussion of WACC and WARA.
4.2.05 Working Capital – The required return on working capital is typically considered to be at the lower end of returns of most, if not all,
other asset classes and is assumed to be equal to the after-tax rate that would be charged to finance working capital. One common approach
is to use the bank prime lending rate, adjusted for risk as needed. Another approach is to use rates associated with commercial paper, as these
represent financing rates for corporations financing items such as accounts receivable or inventory. Another approach is to use rates associated
with 30 to 90 day U.S. Treasury bills with consideration of additional risk factors that might slightly increase the rate of return. As noted earlier,
the Working Group believes that these approaches could understate the required return since very few companies are able to borrow 100% of
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the value of working capital assets. The Working Group believes that a best practice, if it creates a significant difference, would be to consider
the level of debt and equity financing required to fund working capital. When inventory has a limited specific market or when receivables are
in a high default industry it may be appropriate to adjust the various reference rates noted in this paragraph to reflect that additional risk.
4.2.06 Fixed (Tangible) Assets – The required return on fixed (tangible) assets may be estimated through rates of return that market
participants would experience to finance similar assets. The rate of return should reflect the relative risk of the specific asset. Examples of
rates of return on these fixed assets are the calculated after-tax interest rate based on a) observed rates charged by vendor financing, or b)
bank debt that would be used to finance the specific fixed asset. If the asset cannot be financed with all debt (which is often the case) then the
Working Group believes that use of a blended debt and equity rate would be representative of a best practice. As fixed assets become more
risky (such as special purpose assets), it may be appropriate to adjust the various debt rates found in the marketplace.
4.2.07 Intangible Assets – The required rate of return on identified intangible assets may be estimated through the relative risk of the
intangible assets compared to the entity’s overall WACC. Typically intangible assets necessitate a higher rate of return than the WACC, due to
the riskier and less liquid nature of intangible assets relative to working capital and fixed assets. Identified intangible assets and goodwill, in
aggregate, usually have the highest required return of all the asset classes of an entity. Facts and circumstances will dictate the degree to which
specific intangible assets require returns that are different from this aggregate asset class return. Circumstances can arise where the required
return on an intangible asset is at or below the WACC, depending on the relative asset mix in the entity and the specific nature of the intangible
assets. Backlog and short lived intangible assets such as a soon to be replaced developed technology are examples of intangible assets for which
a lower required return may be appropriate. Since intangible assets are not typically financed with debt but with equity, the required rate of
return for intangible assets is often highly correlated with equity rates of return.
4.2.08 IPR&D Assets – There is separate guidance related to the valuation of IPR&D assets. As outlined in the IPR&D Practice Aid, asset
returns need to be determined based on the stage of completion of the IPR&D project and, in certain industries, will approximate venture capital
returns for early stage development companies (to the extent that a discount rate adjustment technique is being used). The valuation specialist
should consider the riskiness of the project and the typical returns in the industry, as not all development projects would yield high venture
capital-like returns. The IPR&D Practice Aid also discusses FASB Statement of Financial Accounting Concepts No. 7 Using Cash Flow Information
and Present Value in Accounting Measurements (“CON 7”) which provides guidance for using present value techniques in financial accounting.
CON 7 describes two theoretical techniques for using present value to estimate fair value. The two theoretical techniques are described in CON
7 (as clarified in FASB ASC Topic 820) can be summarized as:
1. Discount Rate Adjustment Technique: This technique uses a single, most likely set of cash flows discounted at a rate which reflects
the risk of eventually receiving those cash flows. In this technique the risk is incorporated in the development of the discount rate.
2.
Expected Present Value Technique: This technique uses a set of cash flows that represents the probability weighted average of
discreet scenarios and probabilities that capture the array of possible cash flows. The risk of receiving the cash flows is reflected in
the selection of the probability factors and the discount rate used should be reflective of the expected rate of return associated with
the probability-weighted cash flows (which may include a “cash risk premium”).14
14 FASB ASC paragraphs 820-10-55-4 through 820-10-55-20.
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BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
The Working Group notes both techniques may be theoretically acceptable for use in a discounted cash flow (“DCF”) calculation under the
MPEEM. However, when the discount rate used for a specific technique is derived in a fashion different from that for the other assets or for the
entity as a whole, then diagnostics such as WACC to WARA comparisons may be difficult to apply and interpret (see Section 4.3 for discussion
of such diagnostics).
4.2.09 Goodwill (Excess Purchase Price)15 and Other Elements of the Entity Not Recognized Separately – These assets or elements consist
generally of those for which future cash flows are expected that are not associated with otherwise separately identified assets. The uncertain
nature of these prospective cash flows is commonly viewed as having incrementally more risk than separately identified assets. Therefore,
the rate of return appropriate for this class of assets is commonly thought to be greater than that of the separately identified intangible asset
with the next highest rate of return. The WARA analysis can be used as a diagnostic by setting the WARA equal to the calculated WACC and
solving for the implied rate of return on goodwill rather than as a diagnostic that compares the calculated WACC to the calculated WARA. In this
fashion, the valuation specialist can gauge the appropriateness of the returns on other assets by comparing them to the implied rate of return
on goodwill (see Section 4.3 for additional discussion of these diagnostics).
4.2.10 While it is often the case that the goodwill component would be expected to earn the highest return, the Working Group believes that
there are circumstances where returns on elements of goodwill will approach the calculated WACC. For example, an assembled workforce asset,
an element of goodwill, is often assumed to earn a rate of return commensurate with the calculated WACC. The Working Group believes that
the rate of return on elements of goodwill, including residual goodwill, will range from being the highest rate of return of all the assets to a rate
approaching the calculated WACC. The rate of return on goodwill depends on the relative values of the other (identified) assets, their respective
rates of return, and the nature of the risk inherent in the goodwill itself.
4.3 Issues Pertaining to WACC, IRR and WARA
4.3.01 The WACC is calculated as the return on the investment in the subject entity required by market participants, including both debt and
equity investments. The WACC, based on the market participant’s views (based on an assessment of guideline companies), includes the cost of
equity and the after-tax cost of debt weighted by their respective proportions in the market participant’s long-term view of the capital structure
for the subject entity. The WACC that is initially derived from reference to guideline companies might need to be adjusted for specific facts and
circumstances surrounding the entity whose assets are to be valued, but only if those facts and circumstances are consistent with long-term
market participant views. For example, the subject entity may be smaller or less diversified or have higher cash flow growth than the pool of
available guideline companies referenced in developing a market-derived WACC. It is assumed that market participants would reflect these
characteristics in their risk assessment and the WACC would need to be adjusted accordingly. As applied to equity returns, such risk premiums
are often referred to as being “unsystematic” adjustments. The Working Group’s view, however, is that such risk premiums primarily represent
adjustments to systematic risk resulting from a lack of comparability. Either way, judgment must be used regarding adjustments to the WACC for
such factors. The Working Group refers readers to existing financial and valuation literature regarding models for developing the appropriate
rates of return for equity and debt.
15 The Working Group recognizes that there is often a difference between the total amount of goodwill recorded as the result of an acquisition and the amount of goodwill
(or “excess purchase price”) that the valuation specialist is typically dealing with during the valuation. See paragraph 1.10, item C regarding this issue.
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4.3.02 A detailed discussion of the identification of market participants is contained in the text of FASB ASC Topic 820 and is not repeated
here. It should be noted that market participants are not always the same as the guideline companies. The Working Group does caution that
when performing an MPEEM the valuation specialist must not confuse a market participant’s view of the risk of the subject entity with a market
participant’s own overall risk. Nor should it be assumed that the market participant view of the risk of the subject entity matches the risk of an
investment in an identified group of guideline companies before determining that such a group represents a reasonable proxy for the market
participant view.
4.3.03 At times, in a transaction, the actual price paid might differ from the fair value of the acquired entity. While the purchase price is often
the best indication of fair value, the valuation specialist needs to be alert for circumstances when this is not the case and there is evidence of
over payment (if detectable and quantifiable)16 or under payment (bargain purchase). The following paragraphs elaborate on this issue. The
actual price paid is referred to as the “purchase price,” where necessary, to differentiate it from the fair value of the acquired entity.
4.3.04 An implied internal rate of return (“IRR”), simply stated, is the compounded rate of return indicated to be earned on an investment. It
is the rate that equates the amount or value of an investment and the present value of the cash flows assumed to be earned on that investment.
For the purposes of this document, the IRR in a transaction is the discount rate at which the present value of the PFI of the acquired entity
(adjusted if necessary for market participant assumptions) is equal to the purchase price (adjusted if necessary as noted in paragraph 4.3.03).
Because of potential adjustments to the purchase price and to the PFI, the valuation specialist’s IRR may not be consistent with management’s
internal assumptions.
4.3.05 The IRR for an acquisition (based on an adjusted PFI and/or adjusted purchase price, when necessary) should be compared for
consistency to the WACC which is derived based on views of market participants. Both the WACC and IRR should reasonably reflect the perceived
risk of achieving the PFI (adjusted if necessary for market participant assumptions). An IRR that is significantly different from the WACC may
require a reassessment of the purchase price (actual or adjusted), the PFI, and the WACC (see paragraph 4.3.11 for further discussion).
4.3.06 Calculation of an IRR is relatively straightforward in an acquisition scenario. In other types of valuations when there is no purchase
price to serve as a starting point, if the fair value of the entity is determined using multiple valuation methods, an IRR may be calculated using
the PFI and the concluded fair value of the entity based on reconciliation of the valuation methods.
4.3.07 With the reconciliation of the WACC and IRR complete and the stratification of rates of return for the assets established, the Working
Group believes that best practice would indicate an analysis of the WARA. In essence, the comparison of the WACC to the WARA is a diagnostic
that assists the valuation specialist in reconciling the rates of return required by providers of capital (the WACC) with rates of return earned
by various classes of assets (the WARA). Thus, the WARA calculation assists in assessing the reasonableness of the asset-specific returns for
identified intangible assets and the implied (or calculated) return on goodwill.17 The WARA is calculated as the sum of the required rates of return
for normalized working capital, fixed assets, and intangible assets, weighted by each asset’s proportionate share of the total value of the entity
(where “total value of the entity” means the combined value of debt and equity investment required in the subject entity adjusted to reflect a
16 Note that the original text of FASB Statement No. 141(R), Paragraph B382 indicates that, due to problems of identifying and reliably measuring an overpayment at the
acquisition date, overpayments are best addressed through subsequent impairment testing.
17 Refer to Toolkit for alternative reconciliation calculations.
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27
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
taxable purchase – see paragraph 4.3.08). A WARA that remains significantly different from the WACC may require a reassessment of both
the asset values (or levels of assets) and the assumed returns on those assets to determine if they represent market participant assumptions.
4.3.08 The Working Group also notes that many transactions are “non-taxable” and management’s PFI may not reflect the tax benefit (of
amortization or depreciation) implicit in the fair value of underlying assets. In a business combination structured as a taxable purchase, the PFI
and purchase price are likely to reflect the tax benefits. However, in the case of a deal structured as a non-taxable purchase, the Working Group
recommends temporarily adjusting the purchase price for use in the WARA analysis. Because the individual asset values include the tax benefit
of amortization and increased depreciation, the entity value must also be increased for comparison purposes. The Working Group believes the
most straightforward adjustment technique is to calculate the additional tax benefit as if the deal had been structured as a taxable purchase
and add it to the purchase price (see Exhibit A-10 in the Comprehensive Example). This adjustment would be necessary to ensure consistency in
the WARA analysis, since the fair values of depreciable/amortizable assets would incorporate a proportional share of the tax benefit regardless
of the structure of the deal itself (see paragraph 3.1.08).
4.3.09 When performing the WARA calculation, it is important to remember that the asset values used to calculate the WARA need to represent
normal operating levels required to sustain the value of the entity. In other words, all non-operating assets and liabilities are excluded from the
WARA calculation (both from the individual assets included and from the purchase price used in the calculation). For example, a non-operating
asset such as excess cash is excluded, and the WARA calculation reflects only normal levels of working capital for the entity (based on market
participant perspectives).
4.3.10 The WACC, WARA, and IRR (fully adjusted) all should be calculated and, when applicable, compared and contrasted when using the
MPEEM as discussed previously. The Working Group believes that the starting point for an analysis would be the derived market-based WACC
for the acquired (or subject) entity. As stated above, this WACC is based on market participant assumptions specific to the entity’s cash flows.
One diagnostic test would be to compare the WACC to the IRR and reconcile any differences. Another diagnostic test would be to compare the
WACC/IRR to the WARA to assess the reasonableness of the stratification of rates of return (as discussed in Section 4.2).
4.3.11 When the WACC, WARA and IRR do not easily reconcile, the valuation specialist will need to review the assumptions in the PFI to
determine if they reflect market participant assumptions or if they may have acquirer-specific synergies or other assumptions imbedded in the
projections. If the PFI is determined to reflect market participant assumptions, and no acquirer-specific synergies are included, and the WACC,
WARA and IRR still do not reconcile, the Working Group recommends that the valuation specialist undertake additional procedures. These would
include, but are not limited to, the performance of sensitivity analyses, the rechecking of inputs to both PFI and to WACC calculations, and the
undertaking of a search for qualitative factors that would support the existence of either over-payments or bargain purchase conditions.
28
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5.0 Summary
5.1 Intangible assets are often valued using an income approach. Within the income approach, the MPEEM has arisen as a commonly applied
methodology in the valuation of intangible assets.
5.2 The MPEEM is an attribution model in which a stream of revenue and expenses are associated with a particular group of assets that are all
necessary to support earnings associated with a particular subject intangible asset. The assets in this group other than the subject intangible
asset are considered contributory assets. Through application of the MPEEM, earnings attributable to the contributory assets (in the form of
returns on, and sometimes returns of, those assets) are deducted from the earnings stream so that what remains are the excess earnings
attributable to the subject intangible asset. The excess earnings are discounted to present value to derive the fair value of the subject intangible
asset. All assumptions required in application of the MPEEM are to reflect market participant assumptions.
5.3 Contributory assets are defined as assets that are used in conjunction with the subject intangible asset in the realization of prospective
cash flows associated with the subject intangible asset. Assets that do not contribute to the prospective cash flows associated with the subject
intangible asset are not contributory assets.
5.4 The types of asset categories required to support the cash flows associated with a subject intangible asset are based on the facts and
circumstances of the entity and the subject intangible asset (from a market participant perspective) and may be the components of working
capital, fixed (tangible) assets, and/or intangible assets. Care must be taken in determining which assets are contributory assets, what level of
those contributory assets would be considered necessary to support the earnings associated with the subject intangible asset, and how that level
might change over time, all from the perspective of market participants.
5.5 Once the level of contributory assets is determined, charges for the use of those assets by the subject intangible asset, or returns on those
contributory assets (CACs), must be determined. Rates of return on the various contributory assets (and the resulting CACs) generally reflect
the relative riskiness of those assets. In the end, the WACC, IRR, and WARA must be reconciled.
5.6 The application of CACs is essentially an allocation of earnings to the contributory assets. As such, the methodology applied should result in
approximately the same aggregate earnings and asset values. The application of CACs, as either an earnings allocation or an economic charge,
should not create or destroy value.
5.7 Many implementation issues arise in identifying contributory assets, calculating CACs, and associating rates of return with particular
assets. This document seeks to highlight these issues and set forth the Working Group’s view of best practices. The Working Group notes that
professional judgment is necessary in the valuation of any asset and that the purpose of this document is to assist in reducing diversity of
practice in the specific topics addressed by the Monograph. It is the goal of the Working Group that the guidance set forth in this Monograph,
combined with the application of professional judgment, will result in measurements of fair value that represent the highest level of professional
practice and that are consistent with the goals of fair value measurement for financial reporting.
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29
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
6.0 List of Acronyms Used
CAC
EBIT
EBITDA
IPR&D
IRR
IRS
MPEEM
PFI
ROI
RUL
WACC
WARA
Contributory Asset Charge
Earnings Before Interest & Taxes
Earnings Before Interest, Taxes, Depreciation & Amortization
In-Process Research & Development
Implied Internal Rate of Return
Internal Revenue Service
Multi-Period Excess Earnings Method
Prospective Financial Information
Return on Investment
Remaining Useful Life
Weighted Average Cost of Capital
Weighted Average Rate of Return on Assets
30
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7.0 References
AICPA Practice Aid Series, “Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software,
Electronic Devices and Pharmaceutical Industries”
AICPA, “Bibliography of Publications and Web Site Sources in Connection with FASB Statements No. 141 and No. 142”
Appeals and Review Memorandum Number 34 (ARM 34)
Asbra, Marc, CFA. “Contributory Asset Charges in the Excess Earnings Method” Valuation Strategies March/April 2007: 4-17
Financial Accounting Standards Board Accounting Standards Codification Topic 805, Business Combinations (Previously Financial Accounting
Standards Board, Financial Accounting Series, “Statement of Financial Accounting Standards No. 141 (Revised 2007) – Business Combinations”)
Financial Accounting Standards Board Accounting Standards Codification Topic 820, Fair Value Measurements (Previously Financial Accounting
Standards Board, Financial Accounting Series, “Statement of Financial Accounting Standards No. 157 – Fair Value Measurements”)
Gooch, Lawrence B., ASA, “Capital Charges and the Valuation of Intangibles” Business Valuation Review March 1992: 5-21
Grabowski, Roger, ASA and Lawrence B. Gooch, ASA, “Advanced Valuation Methods in Mergers & Acquisitions” Mergers & Acquisitions, Summer
1976: 15-29
Hitchner, J. R. 2006. Financial Valuation. 2nd ed. New Jersey: Wiley
Horvath, James L. and David W. Chodikoff. 2008. Taxation and Valuation of Technology: Theory, Practice, and the Law. Irwin Law
(Canada)
Internal Revenue Service Revenue Ruling 68-609, 1968-2 C.B. 327
International Glossary of Business Valuation Terms as adopted by the following professional societies and organizations:
American Institute of Certified Public Accountants
American Society of Appraisers
National Association of Certified Valuation Analysts
The Canadian Institute of Chartered Business Valuators
The Institute of Business Appraisers
COPYRIGHT © 2010 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
31
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
King, A.M. 2006. Fair Value for Financial Reporting. New Jersey: Wiley, 115
Mard, M.J., J. R. Hitchner, and S.D. Hyden. 2007. Valuation for Financial Reporting. 2nd ed. (New Jersey: Wiley)
Plewa, Franklin, Professor of Accounting at Idaho State and George Friedlob, Professor Clemson University, Understanding Cash Flow. 1985
Pratt, Shannon P., and Roger J. Grabowski. 2008. Cost of Capital. 3rd ed. New Jersey: Wiley
Reilly, R.F., and R.P. Schweihs. 1998. Valuing Intangible Assets. USA: McGraw-Hill
Smith, R.H., and R.L. Parr. 2005. Intellectual Property: Valuation, Exploitation and Infringement Damages. New Jersey: Wiley
Squires, Renton C., “Dual Primary Asset Valuation,” Presentation at the American Society of Appraisers’ Advanced Business Valuation
Conference, Boston, October 20, 2009
Stegink, Rudolf, Marc Schauten, and Gijs de Graaff. “The Discount Rate for Discounted Cash Flow Valuations of Intangible Assets” March 2007
Vulpiani, Marco. “Cost of Capital Estimation for Intangibles Valuation in Purchase Price Allocation,” Business Valuation Review, Volume 27,
Number 1, Spring, 2008
32
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8.0 Glossary
8.1 Glossary of Terms
Business Enterprise
A commercial, industrial, service, or investment entity (or combination thereof) pursuing an economic activity.
[Source: International Glossary of Business Valuation Terms]
Capital Charge
A fair return on an entity’s contributory assets, which are tangible and intangible assets used in the production of income or cash flow
associated with an intangible asset being valued. In this context, income or cash flow refers to an applicable measure of income or cash flow,
such as net income, or operating cash flow before taxes and capital expenditures. A capital charge may be expressed as a percentage return
on [sic]18 an economic rent associated with, or a profit split related to, the contributory assets.
[Source: AICPA Statement on Standards for Valuation Services, Appendix C, Glossary of Additional Terms]
Contributory Asset Charge (CAC)
See Capital Charge.
Cost Approach
A general way of determining a value indication of an individual asset by quantifying the amount of money required to replace the future
service capability of that asset.
[Source: International Glossary of Business Valuation Terms]
Discount Rate Adjustment Technique
The discount rate adjustment technique uses a single set of cash flows from the range of possible estimated amounts, whether contractual or
promised (as is the case for a bond) or most likely cash flows. In all cases, those cash flows are conditional upon the occurrence of specified
events (for example, contractual or promised cash flows for a bond are conditional on the event of no default by the debtor). The discount rate
used in the discount rate adjustment technique is derived from observed rates of return for comparable assets or liabilities that are traded in
the market. Accordingly, the contractual, promised, ore most likely cash flows are discounted at a rate that corresponds to an observed market
rate associated with such conditional cash flows (market rate of return).
[Source: FASB ASC paragraphs 820-10-55-4 through 820-10-55-20 (Formerly Statement of Financial Accounting Standards No. 157,
Appendix B)]
Economic Life
The period of time over which property may generate economic benefits.
[Source: International Glossary of Business Valuation Terms]
18 The word “or” would be more appropriate.
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BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
Fair Value (FV)
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date.
[Source: Financial Accounting Standards Board Accounting Standards Codification Topic 820, Fair Value Measurements (formerly Statement of
Financial Accounting Standards No. 157)]
Fixed Asset
Assets with a physical manifestation. Examples include land and buildings, plant and machinery, fixtures and fittings, tools and equipment, and
assets in the course of construction and development.
[Source: International Valuation Standards, 7th Ed]
Goodwill
An asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually
identified and separately recognized.
[Source: Financial Accounting Standards Board Accounting Standards Codification Topic 805, Business Combinations (formerly Statement of
Financial Accounting Standards No. 141 (Revised 2007))]
Going Concern
An ongoing operating business enterprise.
[Source: International Glossary of Business Valuation Terms]
In-Process Research and Development (IPR&D)
Research and development project that has not yet been completed. Acquired IPR&D is a subset of an intangible asset to be used in R&D
activities.
[Source: AICPA Practice Aid – Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on
Software, Electronic Devices, and Pharmaceutical Industries, 2001, Appendix A, Glossary of Terms]
Income (Income-Based) Approach
A general way of determining a value indication of a business, business ownership interest, security, or intangible asset using one or more
methods that convert anticipated economic benefits into a present single amount.
[Source: International Glossary of Business Valuation Terms]
Intangible Assets
Nonphysical assets such as franchises, trademarks, patents, copyrights, goodwill, equities, mineral rights, securities and contracts (as
distinguished from physical assets), that grant rights and privileges, and have value for the owner.
[Source: International Glossary of Business Valuation Terms]
34
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Internal Rate of Return (IRR)
A discount rate at which the present value of the future cash flows of the investment equals the cost of the investment.
[Source: International Glossary of Business Valuation Terms]
Invested Capital
The sum of equity and debt in a Business Enterprise. Debt is typically a) all interest bearing debt or b) long-term interest-bearing debt.
When the term is used, it should be supplemented by a specific definition in the given valuation context.
[Source: International Glossary of Business Valuation Terms]
Market Participant
Market participants are buyers and sellers in the principal (or most advantageous) market for the asset or liability that are:
a.
Independent of the reporting entity; that is, they are not related parties
b. Knowledgeable, having a reasonable understanding about the asset or liability and the transaction based on all available
information, including information that might be obtained through due diligence efforts that are usual and customary
c. Able to transact for the asset or liability
d. Willing to transact for the asset or liability; that is, they are motivated but not forced or otherwise compelled to do so.
[Source: Financial Accounting Standards Board Accounting Standards Codification Topic 820, Fair Value Measurements (formerly Statement
of Financial Accounting Standards No. 157)]
Market (Market-Based) Approach
A general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more
methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold.
[Source: International Glossary of Business Valuation Terms]
Multi-Period Excess Earnings Method (MPEEM)
A specific application of the discounted cash flow method, which is more broadly a form of the income approach. The most common method
used to estimate the fair value of an intangible asset.
[Source: AICPA Practice Aid – Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on
Software, Electronic Devices, and Pharmaceutical Industries, 2001, Appendix A, Glossary of Terms]
Prospective Financial Information (PFI)
A forecast of expected future cash flows.
[Source: AICPA Practice Aid – Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on
Software, Electronic Devices, and Pharmaceutical Industries, 2001, paragraph 5.2.07]
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BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
Rate of Return
An amount of income (loss) and/or change in value realized or anticipated on an investment, expressed as a percentage of that investment
[Source: International Glossary of Business Valuation Terms]
Relief From Royalty Method
A valuation method used to value certain intangible assets (for example, trademarks and trade names) based on the premise that the only
value that a purchaser of the assets receives is the exemption from paying a royalty for its use. Application of this method usually involves
estimating the fair market value of an intangible asset by quantifying the present value of the stream of market-derived royalty payments
that the owner of the intangible asset is exempted from or “relieved” from paying.
[Source: AICPA Statement on Standards for Valuation Services, Appendix C, Glossary of Additional Terms]
Weighted Average Cost of Capital (WACC)
The cost of capital (discount rate) determined by the weighted average, at market value, of the cost of all financing sources in the business
enterprise’s capital structure.
[Source: International Glossary of Business Valuation Terms]
8.2 Glossary of Entities Referred to in Document
American Institute of Certified Public Accountants (AICPA)
The national, professional organization for Certified Public Accountants in the US. Provides members with resources, information, certification,
and licensing. Established in 1887.
[Source: Derived from the AICPA’s website, www.aicpa.org]
Financial Accounting Standards Board (FASB)
The designated organization in the private sector for establishing standards of financial accounting and reporting. Those standards govern the
preparation of financial reports and are officially recognized as authoritative by the SEC and AICPA.
[Source: Derived from the FASB’s website, www.fasb.org]
Internal Revenue Service (IRS)
A bureau of the Department of the Treasury organized to carry out the responsibilities of the secretary of the Treasury to enforce the internal
revenue laws.
[Source: Derived from the IRS’s website, www.irs.gov]
36
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Appendix A: Comprehensive Example
The Working Group prepared
this comprehensive example
to further
illustrate
the concepts and best practices
introduced
in
the
discussion document.
Comprehensive Example
IMPORTANT NOTE: These sample calculations are for demonstration purposes only and are not intended as the only form of model or calculation, or
final report exhibit, that is acceptable. In some cases, these calculations include details to demonstrate a point made in the Monograph and would not be
expected in a typical analysis.
This Comprehensive Example demonstrates the concepts put forth in this document and applies them in a comprehensive manner to derive the fair value
of customer relationships (as a sample asset) based on the application of the MPEEM. The contributory assets included in this example are as follows:
• Working Capital
• Fixed Assets (Techniques A&B)
• Assembled Workforce
• Trade Name*
• Intellectual Property*
*These assets contribute to the revenue stream used in valuation of the customer relationships. However, because they are valued by use of the relief from royalty method, this is
considered a profit split and contributory asset charges are not applied.
The required rate of return on each asset should be commensurate with the relative risk associated with investment in that particular asset. For additional
discussion, refer to Section 4 of the Monograph.
Exhibit A-1: Entity Value
Exhibit A-2: Tax Depreciation: 7-Year MACRS & Fair Value of Fixed Assets
Exhibit A-3: Adjusted PFI and Entity Value
Exhibit A-4: Working Capital: Incremental Needs and Contributory Asset Charge
Exhibit A-5: Fixed Assets: Contributory Asset Charge Based on Technique A - Average Annual Balance
Exhibit A-6: Fixed Assets: Contributory Asset Charge Based on Technique B - Level Payment
Exhibit A-7: Assembled Workforce: Growth Investment and Contributory Asset Charge
Exhibit A-8: Customer Relationships MPEEM: Fixed Asset Contributory Asset Charge Based on Technique A - Average Annual Balance
Exhibit A-9: Customer Relationships MPEEM: Fixed Asset Contributory Asset Charge Based on Technique B - Level Payment
Exhibit A-10: Weighted Average Return on Assets (WARA)
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37
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
Acronyms
The following acronyms are used in the Appendices:
AWF
DFCF
EBIT
Assembled Workforce
Debt Free Cash Flow
Earnings Before Interest and Taxes
EBITDA
Earnings Before Interest, Taxes, Depreciation, and Amortization
FV
IP
IRR
IRS
PFI
PV
R&D
TAB
WACC
Fair Value
Intellectual Property
Implied Internal Rate of Return
Internal Revenue Service
Prospective Financial Information
Present Value
Research and Development
Tax Amortization Benefit
Weighted Average Cost of Capital
38
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Entity Value (1)
Exhibit A-1
This example assumes that all potential entity-specific synergies and related value have been extracted from the PFI and the purchase price. Based on the market participant
PFI and purchase price of $4,746, the IRR of the transaction is calculated to be 10%. In addition, a market-based WACC of 10% is estimated, which reconciles to the IRR.
This example reflects a non-taxable transaction.
Revenue
Gross Profit
Operating Expenses:
Maintenance R&D (2)
R&D - Future IP (3)
Trade name advertising (4)
Current customer marketing (5)
Future customer marketing (6)
Total marketing
Total G&A
Total Operating Expenses
EBITDA
Depreciation (7)
Amortization (8)
EBIT
Taxes
Debt Free Net Income
less: Incremental Working Capital (9)
add: Depreciation (10)
less: Capital Expenditures
Debt Free Cash Flow
Residual Value (11)
90%
0.5%
2.5%
0.5%
3%
5%
7%
15%
40%
30%
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10 Residual
$
1,000
900
$
1,050
945
$
1,165
1,049
$
1,306
1,175
$
1,456
1,310
$
1,596
1,436
$
1,718
1,546
$
1,823
1,641
$
1,907
1,716
$
1,976
1,778
$
2,035
1,832
5
25
5
27
18
50
70
150
750
286
-
464
186
278
15
286
286
263
5
26
5
26
22
53
74
158
787
302
-
485
194
291
15
302
400
178
6
29
6
23
29
58
82
175
874
337
-
537
215
322
35
337
450
174
7
33
7
18
40
65
91
196
979
377
-
602
241
361
42
377
500
196
7
36
7
13
53
73
102
218
1,092
412
-
680
272
408
45
412
525
250
8
40
8
8
64
80
112
240
1,196
451
-
745
298
447
42
451
541
315
9
43
9
4
73
86
120
258
1,288
478
-
810
324
486
37
478
557
370
9
46
9
2
80
91
128
274
1,367
513
-
854
342
512
32
513
574
419
10
48
10
1
84
95
133
286
1,430
540
-
890
356
534
25
540
591
458
10
49
10
-
89
99
138
296
1,482
562
-
920
368
552
21
562
609
484
10
51
10
-
92
102
142
305
1,527
581
-
946
378
568
18
581
627
504
7,200
PV Factor (12)
10%
0.9535
0.8668
0.7880
0.7164
0.6512
0.5920
0.5382
0.4893
0.4448
0.4044
0.4044
PV DFCF
Entity Value
251
154
137
140
163
186
199
205
204
196
2,911
4,746
(1) Entity Value projections based on market participant assumptions. Excludes entity-specific synergies.
(2) Maintenance R&D applicable to both current and future IP.
(3) R&D expense for the development of future IP.
(4) Advertising expense related to the trade name.
(5) Maintenance marketing expenses specific to current recognizable customer relationships with following revenue (Exhibit A-8 footnote 1):
Customer relationship revenue
Year 1
Year 10
900 855 770 616 431 259 130 65 33 -
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
(6) Marketing expenses related to creating and maintaining unrecognized and future customer relationships.
(7) 7-MACRS tax depreciation based on carry-over tax basis of $745 and projected capital expenditures. For a detailed calculation see Exhibit A-2 of the Toolkit.
(8) Tax basis of intangible assets is zero.
(9) Represents 30% of incremental revenue. A beginning working capital balance of $285 is based on Year 0 revenue of $950.
(10) The residual year difference in depreciation and capital expenditures recognizes the long term growth in the business and the depreciation lag relative to capital
expenditures.
(11) Based on constant growth model assuming a 3% long-term growth rate.
(12) The market participant based IRR is equivalent to the WACC of 10%. The mid-period convention is applied.
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BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
Tax Depreciation: 7-Year MACRS & Fair Value of Fixed Assets (1)
Exhibit A-2
This exhibit summarizes the tax depreciation calculations based on the $1,000 fair value of the fixed assets and 7-year MACRS depreciation. Because CACs related to fixed
assets are based on their fair value (which includes the tax benefit of depreciation), the depreciation reflected in the PFI is restated to reflect the fair value of the fixed assets.
These projected depreciation amounts are reflected in Exhibit A-3.
Depreciation Of:
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10 Residual
FV of Acquired or Current Fixed Assets
$
143
$
245
$
175
$
125
$
89
$
89
$
89
$
45
Capital Expenditures
Total Tax Depreciation
41
184
127
372
212
387
287
412
352
441
411
500
468
557
513
558
540
540
562
562
581
581
(1) 7-Year MACRS applied to the fair value of the fixed assets and projected capital expenditures.
MACRS Percentages
Year 1
14.29%
Year 2
24.49%
Year 3
17.49%
Year 4
12.49%
Year 5
8.93%
Year 6
8.92%
Year 7
8.93%
Year 8
4.46%
40
COPYRIGHT © 2010 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
THE APPRAISAL FOUNDATION « THE MADISON BUILDING « 1155 15TH STREET NW « SUITE 1111 « WASHINGTON, DC 20005
Adjusted PFI and Entity Value
Exhibit A-3
The PFI in this Exhibit is adjusted to reflect the tax benefits that would result from a restatement of the tax basis of certain of the assets to fair value. The tax benefit inherent
in the fair value of an asset is not reflected in the PFI of a non-taxable transaction. For example, the step-up in fixed assets or the fair value of an assembled workforce are
not reflected in the entity’s tax basis and the PFI for the transaction excludes this benefit. In order to maintain consistency between the PFI to be used in valuing the
customer relationships and the fair value of the assets to which a CAC will be applied, the PFI should be adjusted to include the cash flow benefits of the increase in the tax
basis of the contributory assets. The Working Group believes that the fair value of an intangible asset should not differ depending on the tax structure of a particular
transaction. For additional discussion on the applicability of TABs see paragraphs 3.1.08 and 4.3.08 in this Monograph and paragraphs 5.3.9 - 5.3.108 in the 2001 AICPA
IPR&D Practice Aid.
When the PFI is adjusted to include the additional cash flow benefit embedded in the fair value of the contributory assets, this results in an Adjusted Entity Value that is
greater than the Entity Value by an amount equal to the present value of the tax benefits related to the increase in tax basis. The Entity Value is recalculated at the
WACC/IRR of 10% to arrive at the Adjusted Entity Value of $4,855. This increase of $109 is equivalent to the present value of the incremental tax benefit related to the step-
up in the fixed assets and the assembled workforce. This Adjusted Entity Value is used only for reconciliation at this phase of the analysis.
The Working Group recognizes that these adjustments might not be significant to the analysis and may be excluded based on the judgment of the valuation specialist.
Revenue
Gross Profit
Operating Expenses:
Maintenance R&D
R&D - Future IP
Trade name advertising
Current customer marketing
Future customer marketing
Total marketing
Total G&A
Total Operating Expenses
EBITDA
Depreciation (1)
Amortization - AWF (2)
EBIT
Taxes
Debt Free Net Income
less: Incremental Working Capital
add: Depreciation (1)
Amortization - AWF (2)
less: Capital Expenditures
Debt Free Cash Flow
Residual Value
PV Factor (3)
PV DFCF
90%
0.5%
2.5%
0.5%
3%
5%
7%
15%
40%
30%
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10 Residual
$
1,000
$
1,050
$
1,165
$
1,306
$
1,456
$
1,596
$
1,718
$
1,823
$
1,907
$
1,976
$
2,035
900
945
1,049
1,175
1,310
1,436
1,546
1,641
1,716
1,778
1,832
5
25
5
27
18
50
70
150
750
184
20
546
218
328
15
184
20
286
231
5
26
5
26
22
53
74
158
787
372
20
395
158
237
15
372
20
400
214
6
29
6
23
29
58
82
175
874
387
20
467
187
280
35
387
20
450
202
7
33
7
18
40
65
91
196
979
412
20
547
219
328
42
412
20
500
218
7
36
7
13
53
73
102
218
1,092
441
20
631
252
379
45
441
20
525
270
8
40
8
8
64
80
112
240
1,196
500
20
676
270
406
42
500
20
541
343
9
43
9
4
73
86
120
258
1,288
557
20
711
284
427
37
557
20
557
410
9
46
9
2
80
91
128
274
1,367
558
20
789
316
473
32
558
20
574
445
10
48
10
1
84
95
133
286
1,430
540
20
870
348
522
25
540
20
591
466
10
49
10
-
89
99
138
296
1,482
562
20
900
360
540
21
562
20
609
492
10
51
10
-
92
102
142
305
1,527
581
-
946
378
568
18
581
627
504
7,200
10%
0.9535
0.8668
0.7880
0.7164
0.6512
0.5920
0.5382
0.4893
0.4448
0.4044
0.4044
220
185
159
156
176
203
221
218
207
199
2,911
Adjusted Entity Value (4)
4,855
(1) Tax depreciation pursuant to Exhibit A-2 to reflect the fair value of the fixed assets.
(2) Reflects the amortization of the AWF. For purposes of this example the amortization period for the AWF is assumed to be 10 years rather than 15 years as is required
in the U.S. under IRS Code Section 197. 10 years is applied for demonstration purposes as the projections presented are 10 years in length. Tax benefits related to the
future replacement of, or increase in, the AWF are reflected in the operating expenses and no adjustment is required other than for the initial fair value.
(3) The WACC remains at 10%.
(4) The Adjusted Entity Value increase over the Entity Value is due solely to the incremental tax benefits. This Adjusted Entity Value is used only for reconciliation
purposes.
COPYRIGHT © 2010 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
41
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
Working Capital: Incremental Needs and Contributory Asset Charge
Exhibit A-4
The annual average balance of working capital, consistent with assumptions reflected in Exhibits A-1 and A-3, is calculated and an assumed 3% rate of return on working
capital is applied to arrive at the annual CAC (see Section 3 in the Monograph). Working capital used in this analysis excludes non-operating cash and all interest-bearing
debt.
The Working Group recognizes that under circumstances where working capital correlates directly with revenue (as is the case below), discrete annual calculations may not
be required (see the Practical Expedient). However, in those circumstances where the relationship between working capital and revenue is projected to change significantly
(e.g., reduced days receivable), the discrete annual analysis would be considered a best practice. The need to calculate discrete annual working capital CAC assumptions
would be based on the judgment of the valuation specialist.
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10 Residual
Revenue
Beginning Balance Working Capital
add: Incremental Working Capital
Ending Balance Working Capital
Average Balance
$
950
30%
$
1,000
285
15
$
1,050
300
15
$
1,165
315
35
$
1,306
350
42
$
1,456
392
45
$
1,596
437
42
$
1,718
479
37
$
1,823
516
32
$
1,907
548
25
$
1,976
573
21
$
2,035
594
18
300
293
315
308
350
333
392
371
437
415
479
458
516
498
548
532
573
561
594
584
612
603
Mid-period Adjustment Factor (1)
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
Return On (2)
3%
8
9
10
11
12
13
14
15
16
17
17
Percent of Revenue
0.84%
0.84%
0.82%
0.81%
0.81%
0.82%
0.83%
0.83%
0.84%
0.84%
0.85%
(1) The mid-period adjustment is a simplifying adjustment applied to the return on to reflect the changing level of the contributory assets over the year. A further discussion
of this adjustment is provided in the Toolkit. Note: This calculation does not affect the mid-period discounting convention applied to derive present value elsewhere. The
Working Group recognizes that this adjustment is generally minor and its application is based on the judgment of the valuation specialist.
(2) The 3% after-tax return (CAC) is based on market participant assumptions.
42
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THE APPRAISAL FOUNDATION « THE MADISON BUILDING « 1155 15TH STREET NW « SUITE 1111 « WASHINGTON, DC 20005
Fixed Assets: Contributory Asset Charge Based on Technique A - Average Annual Balance
Exhibit A-5
The annual average balance of the fixed assets, consistent with the Adjusted Entity Value projections and the fair value of the fixed assets, is calculated and an assumed 5%
after-tax rate of return on fixed assets is applied to arrive at the annual CAC (see paragraph 3.4.06, Technique A). The return of and on the acquired or current and future fixed
assets is based on an 8-year straight-line remaining economic useful life in accordance with Technique A “Average Annual Balance.”
The Working Group recognizes that under circumstances where the fixed asset CAC as a percent of revenue would remain relatively stable (as is the case below) discrete
annual calculations may not be required. However, in those circumstances where the fixed asset CAC as a percent of revenue is projected to change (e.g., increasing asset
utilization) then the discrete annual analysis would be considered a best practice. The significance of this assumption would be based on the judgment of the valuation
specialist.
Return Of:
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10 Residual
FV of Acquired or Current Fixed Assets (1)
$
250
$
214
$
179
$
143
$
107
$
71
$
36
$
-
$
-
$
-
Capital Expenditures (2):
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Residual
Total Return Of
Percent of Revenue
Return On:
Beginning Balance
add: Capital Expenditures
less: Return Of
Ending Balance
36
36
50
36
50
56
36
50
56
63
36
50
56
63
66
36
50
56
63
66
68
36
50
56
63
66
68
70
36
50
56
63
66
68
70
72
-
50
56
63
66
68
70
72
74
-
-
56
63
66
68
70
72
74
76
-
-
-
63
66
68
70
72
74
76
78
286
300
321
348
378
410
445
481
519
545
567
28.6%
28.6%
27.6%
26.6%
26.0%
25.7%
25.9%
26.4%
27.2%
27.6%
27.9%
1,000
286
286
1,000
1,000
400
300
1,100
1,100
450
321
1,229
1,229
500
348
1,381
1,381
525
378
1,528
1,528
541
410
1,659
1,659
557
445
1,771
1,771
574
481
1,864
1,864
591
519
1,936
1,936
609
545
2,000
2,000
627
567
2,060
Average Fixed Assets
1,000
1,050
1,165
1,305
1,455
1,594
1,715
1,818
1,900
1,968
2,030
Mid-period Adjustment Factor
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
Return On
5%
48
50
56
62
69
76
82
87
91
94
97
Percent of Revenue
4.8%
4.8%
4.8%
4.7%
4.7%
4.8%
4.8%
4.8%
4.8%
4.8%
4.8%
Total Return Of & On as Percent of Revenue
33%
33%
32%
31%
31%
30%
31%
31%
32%
32%
33%
(1) The economic depreciation (return of ) of the acquired or current fixed assets is based on the fair value of the fixed assets of $1,000 as follows:
Remaining Economic Life (Years)
FV
Year 4
Year 3
Year 2
Year 1
35.7 35.7
71.4 35.7 35.7
107.1 35.7 35.7 35.7
142.9 35.7 35.7 35.7 35.7
178.6 35.7 35.7 35.7 35.7 35.7
214.3 35.7 35.7 35.7 35.7 35.7 35.7
250.0 35.7 35.7 35.7 35.7 35.7 35.7 35.7
Total (rounded) 1,000 250 214 179 143 107 71 36
1
2
3
4
5
6
7
Year 6
Year 5
Year 7
(2) Based on an 8-year economic life with the first year's return on occurring in the year of purchase.
COPYRIGHT © 2010 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
43
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
Fixed Assets: Contributory Asset Charge Based on Technique B - Level Payment
Exhibit A-6
In Technique B, the CAC reflects both the return of and on and is calculated as a series of level annual payments based on an assumed 5% after-tax rate of return on fixed
assets (see paragraph 3.4.10, Technique B). In this exhibit, the CAC is calculated as a "loan payment" at the after-tax rate of return, or interest rate (with the loan payment
conceptually including both principle and interest). The calculation incorporates the fair value of the fixed assets and the remaining useful life for each asset group (waterfall
payment) and assumes an 8-year remaining useful life for capital expenditures in each year, consistent with the Adjusted Entity Value projections and the fair value of the
fixed assets.
The Working Group recognizes that under circumstances where the fixed asset CAC as a percent of revenue would remain relatively stable (as is the case below) discrete
annual calculations may not be required. However, in those circumstances where the fixed asset CAC as a percent of revenue is projected to change (e.g., increasing asset
utilization) then the discrete annual analysis would be considered a best practice. The significance of this assumption would be based on the judgment of the valuation
specialist.
Return On and Of:
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10 Residual
FV of Acquired or Current Fixed Assets (1)
1-year
2-years
3-years
4-years (2)
5-years
6-years
7-years
8-years
Capital Expenditures (3):
Year 1 (4)
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Residual
Total Return On & Of
% of Revenue
37
38
39
40
41
42
43
-
42
38
39
40
41
42
43
-
42
59
39
40
41
42
43
-
42
59
66
40
41
42
43
-
42
59
66
74
41
42
43
-
42
59
66
74
77
42
43
-
42
59
66
74
77
80
43
-
42
59
66
74
77
80
82
-
42
59
66
74
77
80
82
85
-
59
66
74
77
80
82
85
87
-
-
66
74
77
80
82
85
87
90
-
-
-
74
77
80
82
85
87
90
92
324
32%
346
33%
373
32%
408
31%
445
31%
483
30%
523
30%
565
31%
610
32%
641
32%
667
33%
(1) The level payment related to the acquired or current fixed assets is based on the fair value of the fixed assets of $1,000 with an equal distribution of original cost over
the prior 8 years, similar to Exhibit A-5. This waterfall calculation reflects individual level payment calculations for each asset life group.
(2) Sample calculation of the level payment for the acquired fixed assets with a remaining useful life of 4 years is as follows:
CAC = -PMT(After-Tax Rate of Return,RUL,Fair Value,Future Value,Type = beginning of period) x (1+Discount Rate)^.5
= -PMT(5%,4,143,0,1) x (1 + 10%)^.5 =
40
(3) Individual level payment calculations for annual capital expenditures.
(4) Sample calculation of the level payment for the $286 of capital expenditures occurring in Year 1 with a remaining useful life of 8 years is as follows:
CAC = -PMT(After-Tax Rate of Return,RUL,Fair Value,Future Value,Type = beginning of period)
= -PMT(5%,8,286,0,1) =
42
44
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THE APPRAISAL FOUNDATION « THE MADISON BUILDING « 1155 15TH STREET NW « SUITE 1111 « WASHINGTON, DC 20005
Assembled Workforce: Growth Investment and Contributory Asset Charge
Exhibit A-7
This exhibit calculates the growth investment in AWF and the return on the AWF (the CAC). The fair value of the acquired or current AWF of $200 is estimated based on the
pre-tax replacement cost.
Future operating expenses include the cost to both grow and maintain the AWF. The initial investment to increase the AWF should be excluded to avoid double counting the
initial investment and the future maintenance expenses. In other words, the return on the AWF would increase due to its growth and future operating expenses provide for
maintaining the increase in the AWF (see Section 3.7 of the Monograph). The Working Group recognizes that this adjustment is generally minor and may be excluded in
practice. However, such an adjustment provides for a complete reconciliation of value in the context of a financial overlay as discussed in the Toolkit.
The Working Group recognizes that under circumstances where the relationship between AWF and revenue (e.g., the revenue per employee) remains relatively stable,
discrete annual calculations may not be required (see the Practical Expedient). However, in those circumstances where the relationship is projected to significantly change
(e.g., increasing revenue per employee), the discrete annual analysis would be considered a best practice. The need for discrete AWF calculations (and the resulting AWF
CAC) would be based on the judgment of the valuation specialist.
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10 Residual
Revenue
Growth
$
1,000
5%
$
1,050
5%
$
1,165
11%
$
1,306
12%
$
1,456
11%
$
1,596
10%
$
1,718
8%
$
1,823
6%
$
1,907
5%
$
1,976
4%
$
2,035
3%
Beginning Balance
add: Pre-Tax Investment in AWF Growth (1)
Ending Balance
Average Balance
200
11
211
206
211
11
222
217
222
24
246
234
246
30
276
261
276
32
308
292
308
30
338
323
338
26
364
351
364
22
386
375
386
18
404
395
404
15
419
412
419
13
432
426
Mid-period Adjustment Factor
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
0.9535
Return On (2)
10%
20
21
22
25
28
31
33
36
38
39
41
Percent of Revenue
2.0%
2.0%
1.9%
1.9%
1.9%
1.9%
1.9%
2.0%
2.0%
2.0%
2.0%
(1) Growth investment correlates to the annual increase in revenue. For example in Year 2 revenue increases by 5% and the AWF grows by $11 (5% x $211).
(2) The required rate of return on identified intangible assets such as the AWF may be estimated through the relative risk of the intangible assets compared to the entity’s
overall WACC.
COPYRIGHT © 2010 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
45
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
Customer Relationships MPEEM: Fixed Asset Contributory Asset Charge Based on Technique A - Average Annual Balance
Exhibit A-8
This exhibit uses the Average Annual Balance technique (Technique A) for the calculation of fixed asset CACs in the valuation of customer relationships using an MPEEM.
Aggregate CACs were estimated in the prior exhibits. An analysis of the subject intangible asset should be performed to assess the required levels of contributory assets.
The aggregate CACs on those assets are then allocated appropriately to the subject intangible asset. For the purposes of this example all contributory assets have been
assumed to benefit all customers equally and the CACs are allocated in proportion to revenue. The allocation of CACs is based on facts and circumstances. For example, in
other circumstances a disproportionate amount of the fixed assets may be used to manufacture the products sold to the identified customer relationships ($900 in revenue in
Year 1) versus the unidentified customers ($100 in Year 1). In a similar manner, the IP may be disproportionately allocable to the identified customer relationships rather than
the unidentified customers.
In addition to the CACs related to working capital, fixed assets and AWF, profit splits in the form of royalty rates were also applied for the use of the trade name and IP. This
example assumes that certain expense items (e.g., advertising and R&D) are included in the royalty rate and have been eliminated from the excess earnings to avoid double
counting the expense.
Total Revenue
$
1,000
$
1,050
$
1,165
$
1,306
$
1,456
$
1,596
$
1,718
$
1,823
$
1,907
$
1,976
$
2,035
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10 Residual
90%
0.0%
0.0%
0.0%
3%
7%
5%
10%
40%
Customer Relationship Revenue (1)
Gross Profit
Operating Expenses:
Maintenance R&D (2)
R&D - Future IP (2)
Trade name advertising (3)
Current customer marketing (4)
Future customer marketing (5)
Total marketing
Total G&A
Total Operating Expenses
EBITDA
Depreciation (6)
Amortization - AWF (8)
EBIT
less: Trade Name Royalty (7)
IP Royalty (7)
Adjusted EBIT
Taxes
Debt Free Net Income
add: Depreciation (6)
Amortization - AWF (8)
AWF Growth Investment (9)
less: Return On Working Capital (10)
Return Of Fixed Assets (11)
Return On Fixed Assets (11)
Return On AWF (9)
Excess Earnings
900
810
-
-
-
27
-
27
63
90
720
166
18
536
45
90
401
160
241
166
18
10
8
257
43
18
109
855
770
-
-
-
26
-
26
60
86
684
303
16
365
43
86
236
94
142
303
16
9
7
244
41
17
161
770
693
-
-
-
23
-
23
54
77
616
256
13
347
39
77
231
92
139
256
13
16
6
212
37
15
154
616
554
-
-
-
18
-
18
43
61
493
194
9
290
31
62
197
79
118
194
9
14
5
164
29
12
125
431
388
-
-
-
13
-
13
30
43
345
131
6
208
22
43
143
57
86
131
6
9
4
112
20
8
88
259
233
-
-
-
-
8
8
18
26
207
81
3
123
13
26
84
34
50
81
3
5
2
67
12
5
53
130
117
-
-
-
-
4
4
9
13
104
42
2
60
7
13
40
16
24
42
2
2
1
34
6
2
27
65
59
-
-
-
-
2
2
5
7
52
20
1
31
3
7
21
8
13
20
1
1
1
17
3
1
13
33
30
-
-
-
-
1
1
2
3
27
9
-
18
2
3
13
5
8
9
-
-
-
9
2
1
5
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
PV Factor (12)
10%
0.9535
0.8668
0.7880
0.7164
0.6512
0.5920
0.5382
0.4893
0.4448
0.4044
0.4044
PV Excess Earnings
Total PV Excess Earnings
Tax Amortization Benefit (13)
Fair Value - Customer Relationships
104
566
153
719
140
121
90
57
31
15
6
2
-
-
46
COPYRIGHT © 2010 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
THE APPRAISAL FOUNDATION « THE MADISON BUILDING « 1155 15TH STREET NW « SUITE 1111 « WASHINGTON, DC 20005
Customer Relationships MPEEM: Fixed Asset Contributory Asset Charge Based on Technique A - Average Annual Balance (Continued)
Exhibit A-8
(1) Assumed to decline over a 9 year period. Therefore, calculations only continue for those 9 years.
(2) Maintenance and future R&D is assumed to be included in the 10% IP royalty rate (licensor responsible for all R&D in the future) and is therefore removed in the excess
earnings. The R&D expenses would be reflected as a reduction to the royalty in the valuation of the IP. Alternately, it might be determined that the royalty rate is stated
net of the R&D expenses in which case the R&D expenses would remain in the excess earnings.
(3) Advertising expenses removed under the same assumptions provided in footnote 2.
(4) Maintenance marketing expenses specific to current recognizable customer relationships.
(5) Marketing expenses related to creating and maintaining unrecognized and future customer relationships are excluded.
(6) Exhibit A-2 amounts allocated in proportion to revenue.
(7) Royalty rates assumed to be gross (e.g., inclusive of advertising and R&D expenses). The same rates would be incorporated in the valuation of the trade name and IP.
Note that the royalty charge is applicable to both current and future contributory assets (see paragraphs 3.6.02 - 3.6.04).
(8) Exhibit A-3 amounts allocated in proportion to revenue.
(9) Exhibit A-7 amounts allocated in proportion to revenue.
(10) Exhibit A-4 amounts allocated in proportion to revenue.
(11) Exhibit A-5 amounts allocated in proportion to revenue.
(12) Discount rate assumed to be equivalent to the IRR/WACC and a mid-period convention.
(13) Based on a 15 year straight-line amortization period, 40% tax rate and a 10% discount rate using a mid-period convention.
COPYRIGHT © 2010 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
47
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
Customer Relationships MPEEM: Fixed Asset Contributory Asset Charge Based on Technique B - Level Payment
Exhibit A-9
Applies the Level Payment methodology for fixed assets to the customer relationships. All other CACs and adjustments discussed in Exhibit A-8 remain the same.
Total Revenue
$
1,000
$
1,050
$
1,165
$
1,306
$
1,456
$
1,596
$
1,718
$
1,823
$
1,907
$
1,976
$
2,035
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10 Residual
Customer Relationship Revenue
Gross Profit
Operating Expenses:
Maintenance R&D
R&D - Future IP
Trade name advertising
Current customer marketing
Future customer marketing
Total marketing
Total G&A
Total Operating Expenses
EBITDA
Depreciation
Amortization - AWF
EBIT
less: Trade Name Royalty
IP Royalty
Adjusted EBIT
Taxes
Debt Free Net Income
add: Depreciation
Amortization - AWF
AWF Growth Investment
less: Return On Working Capital
Return On & Of Fixed Assets (1)
Return On AWF
Excess Earnings
PV Factor
PV Excess Earnings
Total PV Excess Earnings
Tax Amortization Benefit
Fair Value - Customer Relationships
90%
0.0%
0.0%
0.0%
3%
7%
5%
10%
40%
900
810
-
-
-
27
-
27
63
90
720
166
18
536
45
90
401
160
241
166
18
10
8
292
18
117
855
770
-
-
-
26
-
26
60
86
684
303
16
365
43
86
236
94
142
303
16
9
7
281
17
165
770
693
-
-
-
23
-
23
54
77
616
256
13
347
39
77
231
92
139
256
13
16
6
247
15
156
616
554
-
-
-
18
-
18
43
61
493
194
9
290
31
62
197
79
118
194
9
14
5
192
12
126
431
388
-
-
-
13
-
13
30
43
345
131
6
208
22
43
143
57
86
131
6
9
4
132
8
88
259
233
-
-
-
-
8
8
18
26
207
81
3
123
13
26
84
34
50
81
3
5
2
78
5
54
130
117
-
-
-
-
4
4
9
13
104
42
2
60
7
13
40
16
24
42
2
2
1
40
2
27
65
59
-
-
-
-
2
2
5
7
52
20
1
31
3
7
21
8
13
20
1
1
1
20
1
13
33
30
-
-
-
-
1
1
2
3
27
9
-
18
2
3
13
5
8
9
-
-
-
11
1
5
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
10%
0.9535
0.8668
0.7880
0.7164
0.6512
0.5920
0.5382
0.4893
0.4448
0.4044
0.4044
143
123
90
57
32
15
6
2
-
-
112
580
157
737
(1) Exhibit A-6 amounts allocated in proportion to revenue.
48
COPYRIGHT © 2010 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
THE APPRAISAL FOUNDATION « THE MADISON BUILDING « 1155 15TH STREET NW « SUITE 1111 « WASHINGTON, DC 20005
Weighted Average Return on Assets (WARA)
Exhibit A-10
The WARA analysis is applied to the fair value of the assets and the implied rate of return on goodwill (excess purchase price) is calculated. The purpose of the WARA is the
assessment of the reasonableness of the asset-specific returns for identified intangibles and the implied (or calculated) return on the goodwill (excess purchase price). The
WARA then should be compared to the derived market-based WACC (see paragraph 4.3.07).
Working Capital (1)
Fixed Assets (2)
Trade Name (3)
IP (3)
Customer Relationships (4)
AWF (5)
Excess Purchase Price (6)
Average Annual Balance
Fair
Value
Rate of Weighted
Return
Return
Level Payment
Fair
Value
Rate of Weighted
Return
Return
$
285
1,000
80
196
719
200
3,145
3%
5%
10%
10%
10%
10%
12.2%
$
8.6
50.0
8.0
19.6
71.9
20.0
383.7
$
285
1,000
80
196
737
200
3,144
3%
5%
10%
10%
10%
10%
12.2%
$
8.6
50.0
8.0
19.6
73.7
20.0
383.6
Total (7)
5,625
10.0%
561.7
5,642
10.0%
563.4
(1) Exhibit A-4.
(2) Exhibit A-5.
(3) See Toolkit for the valuation of these assets.
(4) Exhibits A-8 and A-9. The Working Group believes that both of these values are within an acceptable range of results as the difference is the result of timing differences
inherent in the CAC calculations.
(5) Exhibit A-7.
(6) Other than AWF. In a business combination, actual recorded goodwill will differ from this due to other purchase accounting adjustments.
(7) Includes the depreciation tax benefit from the increase in fixed asset value and the TAB on all intangible assets.
COPYRIGHT © 2010 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
49
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
THIS PAGE INTENTIONALLY LEFT BLANK.
50
COPYRIGHT © 2010 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
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Appendix B: Practical Expedient
The Working Group prepared this example of practical expedients to better illustrate simplifying assumptions that are often
appropriate.
Practical Expedient Example
IMPORTANT NOTE: These sample calculations are for demonstration purposes only and are not intended as the only form of model or calculation, or
final report exhibit, that is acceptable. In some cases, these calculations include details to demonstrate a point made in the Monograph and would not be
expected in a typical analysis. In this example, a practical expedient was not used for the AWF calculations related to its amortization and the add-back
of growth investments. Because of the fact pattern in this example (AWF fair value is high relative to the fair value of the customer relationships), using
a practical expedient for the AWF has a significant affect on the FV of the subject intangible asset.
This example demonstrates concepts put forth in this Monograph. It provides a practical expedient in circumstances when certain assumptions can be made
with regard to the application of CACs. Whether or not these practical expedients are appropriate should be evaluated by the valuation specialist and, to
the extent that they are applied, the assumptions should be clearly stated in the analysis. The contributory assets included in this example are as follows:
• Working Capital
• Fixed Assets
• Assembled Workforce
• Trade Name*
• Intellectual Property*
*These assets contribute to the revenue stream used in the valuation of the customer relationships. However, because they are valued by use of the relief from royalty method, this
is considered a profit split and contributory asset charges are not applied.
The simplifying assumptions include the following:
• The use of accounting depreciation in combination with an appropriate effective tax rate approximates the effect of tax depreciation;
• The projections of fixed asset depreciation reflected in the PFI approximate a detailed waterfall calculation of existing basis in the fixed assets with
an adjustment for step up, if any, to the fixed asset fair value;
• Future levels of contributory assets (non-income based: working capital, fixed assets, and AWF) are closely correlated with revenue and can be
approximately represented with a “percent of revenue” calculation.
Exhibit B-1: Entity Value
Exhibit B-1a: Depreciation: $745 of Financial Reporting Basis with an 8-Year Straight-Line Depreciation
Exhibit B-2: Adjusted PFI and Entity Value
Exhibit B-2a: Incremental Depreciation due to the $255 Fair Value Step-up with an 8-Year Straight-Line Depreciation
Exhibit B-3: Contributory Asset Charges - Basis for Practical Expedients
Exhibit B-4: Contributory Asset Charges
Exhibit B-5: Customer Relationships MPEEM: Practical Expedients
COPYRIGHT © 2010 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
51
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
Entity Value (1)
Exhibit B-1
The Entity Value in this Practical Expedient is based on 8-year straight-line depreciation (rather than tax depreciation) and an effective tax rate to equate to the Entity Value in
the Comprehensive Example. Based on the market participant PFI and purchase price of $4,746, the IRR of the transaction is calculated to be 10%. In addition a market-
based WACC of 10% is estimated, which reconciles to the IRR. This example reflects a non-taxable transaction.
Revenue
Gross Profit
Operating Expenses:
Maintenance R&D (2)
R&D - Future IP (3)
Trade name advertising (4)
Current customer marketing (5)
Future customer marketing (6)
Total marketing
Total G&A
Total Operating Expenses
EBITDA
Depreciation (7)
Amortization (8)
EBIT
Taxes (9)
Debt Free Net Income
less: Incremental Working Capital (10)
add: Depreciation (11)
30%
less: Capital Expenditures
Debt Free Cash Flow
Residual Value (12)
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10 Residual
$
1,000
900
$
1,050
945
$
1,165
1,049
$
1,306
1,175
$
1,456
1,310
$
1,596
1,436
$
1,718
1,546
$
1,823
1,641
$
1,907
1,716
$
1,976
1,778
$
2,035
1,832
90%
0.5%
2.5%
0.5%
3%
5%
7%
15%
38.4%
5
25
5
27
18
50
70
150
750
222
-
528
203
325
15
222
286
246
5
26
5
26
22
53
74
158
787
246
-
541
208
333
15
246
400
164
6
29
6
23
29
58
82
175
874
275
-
599
230
369
35
275
450
159
7
33
7
18
40
65
91
196
979
311
-
668
256
412
42
311
500
181
7
36
7
13
53
73
102
218
1,092
351
-
741
284
457
45
351
525
238
8
40
8
8
64
80
112
240
1,196
392
-
804
308
496
42
392
541
305
9
43
9
4
73
86
120
258
1,288
436
-
852
327
525
37
436
557
367
9
46
9
2
80
91
128
274
1,367
481
-
886
340
546
32
481
574
421
10
48
10
1
84
95
133
286
1,430
519
-
911
350
561
25
519
591
464
10
49
10
-
89
99
138
296
10
51
10
-
92
102
142
305
1,482
545
-
1,527
567
-
937
359
578
21
545
609
493
960
368
592
18
567
627
514
7,343
PV Factor (13)
10%
0.9535
0.8668
0.7880
0.7164
0.6512
0.5920
0.5382
0.4893
0.4448
0.4044
0.4044
PV DFCF
Entity Value
235
142
125
130
155
181
198
206
206
199
2,969
4,746
(1) Entity Value projections based upon market participant assumptions. Excludes entity-specific synergies.
(2) Maintenance R&D applicable to both current and future IP.
(3) R&D expense for the development of future IP.
(4) Advertising expense related to the trade name.
(5) Maintenance marketing expenses specific to current recognizable customer relationships with following revenue (Exhibit B-5 footnote 1):
Customer relationship revenue
Year 1
Year 10
900 855 770 616 431 259 130 65 33 -
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
(6) Marketing expenses related to creating and maintaining unrecognized and future customer relationships.
(7) From Exhibit B-1a.
(8) Tax basis of intangible assets is zero.
(9) The effective tax rate is calculated such that the Entity Value is equivalent to that provided in the Comprehensive Example. Tax rate is not rounded.
(10) Represents 30% of incremental revenue. A beginning working capital balance of $285 is based on Year 0 revenue of $950.
(11) The residual year difference in depreciation and capital expenditures recognizes the long term growth in the business and the depreciation lag relative to capital
expenditures.
(12) Based on constant growth model assuming a 3% long-term growth rate.
(13) The market participant based IRR is equivalent to the WACC of 10%. The mid-period convention is applied.
52
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Depreciation: $745 of Financial Reporting Basis with an 8-Year Straight-Line Depreciation (1)
Exhibit B-1a
This is a reference schedule for the projected depreciation reflected in the Entity Value. The valuation specialist should have an understanding of the assumptions reflected in,
and the calculation of, the depreciation provided in the PFI. Such an understanding will allow for an assessment of the reasonableness of the simplifying assumption that the
tax depreciation and statutory tax rate are reasonably approximated by accounting depreciation and the effective tax rate.
Straight-Line Depreciation Of:
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10 Residual
Acquired or Current Fixed Assets (2)
$
186
$
160
$
133
$
106
$
80
$
53
$
27
$
-
$
-
$
-
Capital Expenditures (3):
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Residual
36
36
50
36
50
56
36
50
56
63
36
50
56
63
66
36
50
56
63
66
68
36
50
56
63
66
68
70
36
50
56
63
66
68
70
72
-
50
56
63
66
68
70
72
74
-
-
56
63
66
68
70
72
74
76
-
-
-
63
66
68
70
72
74
76
78
Total Depreciation (4)
222
246
275
311
351
392
436
481
519
545
567
Fixed Asset Turnover
Beginning Balance
add: Capital Expenditures
less: Depreciation
Ending Balance
Average Fixed Assets
745
286
222
809
777
809
400
246
963
886
963
450
275
1,138
1,138
500
311
1,327
1,327
525
351
1,501
1,501
541
392
1,650
1,650
557
436
1,771
1,771
574
481
1,864
1,864
591
519
1,936
1,936
609
545
2,000
2,000
627
567
2,060
1,051
1,233
1,414
1,576
1,711
1,818
1,900
1,968
2,030
Fixed Asset Turnover
129%
119%
111%
106%
103%
101%
100%
100%
100%
100%
100%
(1) Assumes accounting depreciation in combination with an effective tax rate is a reasonable proxy for tax depreciation in combination with the statutory tax rate and is
included in the PFI.
(2) The carrying value of the fixed assets is $745 and the annual depreciation is assumed.
(3) Straight-line over 8 years with the first year of depreciation recognized in the year of acquisition.
(4) As reflected in the PFI.
COPYRIGHT © 2010 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
53
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
Adjusted PFI and Entity Value
Exhibit B-2
The PFI in this exhibit is adjusted to reflect the tax benefits that would result from a restatement of the tax basis of certain of the assets to fair value. The tax benefit inherent in
the fair value of an asset is not reflected in the PFI of a non-taxable transaction. For example, the step-up in fixed assets or the fair value of an assembled workforce are not
reflected in the entity’s tax basis and the PFI for the transaction excludes this benefit. In order to maintain consistency between the PFI to be used in valuing the customer
relationships and the fair value of the assets to which a CAC will be applied, the PFI should be adjusted to include the cash flow benefits of the increase in the tax basis of the
contributory assets. The Working Group believes that the fair value of an intangible asset should not differ depending on the tax structure of a particular transaction. For
additional discussion on the applicability of TABs see paragraphs 3.1.08 and 4.3.08 in this Monograph and paragraphs 5.3.9 - 5.3.108 in the 2001 AICPA IPR&D Practice Aid.
When the PFI is adjusted to include the additional cash flow benefit embedded in the fair value of the contributory assets, this results in an Adjusted Entity Value that is greater
than the Entity Value by an amount equal to the present value of the tax benefits related to the increase in tax basis. The Entity Value is recalculated at the WACC/IRR of 10%
to arrive at the Adjusted Entity Value of $4,872. This increase of $126 is equivalent to the present value of the incremental tax benefit related to the step-up in the fixed assets
and the assembled workforce. This Adjusted Entity Value is used only for reconciliation at this phase of the analysis.
The Working Group recognizes that these adjustments might not be significant to the analysis and may be excluded based on the judgment of the valuation specialist.
Revenue
Gross Profit
Operating Expenses:
Maintenance R&D
R&D - Future IP
Trade name advertising
Current customer marketing
Future customer marketing
Total marketing
Total G&A
Total Operating Expenses
EBITDA
Depreciation (1)
Depreciation of fixed asset step-up (2)
Adjusted Depreciation
Amortization - AWF (3)
EBIT
Taxes
Debt Free Net Income
less: Incremental Working Capital
add: Adjusted Depreciation
Amortization - AWF (3)
less: Capital Expenditures
Debt Free Cash Flow
Residual Value
PV Factor (4)
PV DFCF
90%
0.5%
2.5%
0.5%
3%
5%
7%
15%
38%
30%
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10 Residual
$
1,000
900
$
1,050
945
$
1,165
1,049
$
1,306
1,175
$
1,456
1,310
$
1,596
1,436
$
1,718
1,546
$
1,823
1,641
$
1,907
1,716
$
1,976
1,778
$
2,035
1,832
5
25
5
27
18
50
70
150
750
222
63
285
20
445
171
274
15
285
20
286
278
5
26
5
26
22
53
74
158
787
246
54
300
20
467
179
288
15
300
20
400
193
6
29
6
23
29
58
82
175
874
275
45
320
20
534
205
329
35
320
20
450
184
7
33
7
18
40
65
91
196
979
311
36
347
20
612
235
377
42
347
20
500
202
7
36
7
13
53
73
102
218
1,092
351
27
378
20
694
266
428
45
378
20
525
256
8
40
8
8
64
80
112
240
1,196
392
18
410
20
766
294
472
42
410
20
541
319
9
43
9
4
73
86
120
258
1,288
436
9
445
20
823
316
507
37
445
20
557
378
9
46
9
2
80
91
128
274
1,367
481
-
481
20
866
332
534
32
481
20
574
429
10
48
10
1
84
95
133
286
1,430
519
-
519
20
891
342
549
25
519
20
591
472
10
49
10
-
89
99
138
296
10
51
10
-
92
102
142
305
1,482
545
1,527
567
-
545
20
917
352
565
21
545
20
609
500
-
567
-
960
368
592
18
567
627
514
7,343
10%
0.9535
0.8668
0.7880
0.7164
0.6512
0.5920
0.5382
0.4893
0.4448
0.4044
0.4044
265
167
145
145
167
189
203
210
210
202
2,969
Adjusted Entity Value (5)
4,872
(1) From Exhibit B-1.
(2) See sample calculation in Exhibit B-2a.
(3) Reflects the amortization of the AWF. For purposes of this example the amortization period for the AWF is assumed to be 10 years rather than 15 years as is required
in the U.S. under IRS Code Section 197. 10 years is applied for demonstration purposes as the projections presented are 10 years in length. Tax benefits related to the
future replacement of, or increase in, the AWF are reflected in the operating expenses and no adjustment is required other than for the initial fair value.
(4) The WACC is not adjusted for the inclusion of the incremental tax benefit and remains at 10%.
(5) The Adjusted Entity Value increase over the Entity Value is due solely to the incremental tax benefits. This Adjusted Entity Value is used only for reconciliation purposes.
54
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Incremental Depreciation due to the $255 Fair Value Step-up with an 8-Year Straight-Line Depreciation (1)
Exhibit B-2a
This is a reference schedule for the projected depreciation reflected in the Adjusted Entity Value and also provides the fixed asset turnover based on the fair value of the fixed
assets. The valuation specialist should have an understanding of the assumptions reflected in, and the calculation of, the depreciation provided in the PFI. Such an
understanding will allow for an assessment of the reasonableness of the simplifying assumption that the tax depreciation and statutory tax rate are reasonably approximated by
accounting depreciation and the effective tax rate.
RUL (Years)
1
Step-up
Year 1
9 9
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
2
3
4
5
6
7
18 9
9
27 9
9
9
36 9
9
9
9
45 9
9
9
9
9
54 9
63 9
9
9
9
9
9
9
9
9
9
9
9
Total (rounded) (2) 252
63 54 45 36 27 18 9
Fixed Asset Turnover (3)
Beginning Balance
1,000
1,001
1,101
1,231
1,384
1,531
1,662
1,774
1,867
1,939
2,003
add: Capital Expenditures
less: Depreciation from Exhibit B-1a
less: Incremental depreciation above
286
222
63
400
246
54
450
275
45
500
311
36
525
351
27
541
392
18
557
436
9
574
481
-
591
519
-
609
545
-
627
567
-
Ending Balance
1,001
1,101
1,231
1,384
1,531
1,662
1,774
1,867
1,939
2,003
2,063
Average Fixed Assets
1,001
1,051
1,166
1,308
1,458
1,597
1,718
1,821
1,903
1,971
2,033
Fixed Asset Turnover (4)
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
(1) Calculates the incremental depreciation due to the recognition of the fair value of the fixed assets. This is applied as an incremental amount to the depreciation reflected in
Exhibit B-1. This example assumes that 1 year of depreciation was recognized in the year of acquisition, therefore 7 years of depreciation remain for the assets acquired in
the prior year. The $3 difference from $255 is due to rounding.
(2) Reflects the incremental depreciation due to the recognition of the fair value of the fixed assets.
(3) The fixed asset turnover is provided to assess the ongoing relationship between the fixed assets and revenue. To the extent that the fixed asset turnover remains relatively
constant, the practical expedient assumption may be appropriate. If there is a period during the early years of the projection where the relationship between fixed assets and
revenue is migrating towards a long-term normalized amount, then this assumption should be applied on a blended basis or for periods after which a normalized amount is
achieved. If, however, the turnover rate continues to vary significantly over the forecast period, the practical expedient assumption might not be appropriate.
(4) Annual revenue / average fixed assets.
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55
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
Contributory Asset Charges - Basis for Practical Expedients
Exhibit B-3
One of the fundamental premises of a CAC is that investments made at a point in time have economic benefits extending beyond the year the investment was made. A CAC
essentially replaces the initial investment with an annual charge over the life of the investment such that the PV of the charge is equivalent to the initial investment. In other
words the PV impact to the projections is zero. This applies to the initial fair value of the acquired or current contributory asset as well as future investments that increase the
investment in the respective contributory assets.
Working Capital: The initial balance is replaced with a perpetual return on . The nature of working capital (see paragraph 3.2.01) removes the need to provide a return of the
asset over its RUL. Further, each annual investment in incremental working capital is replaced with a perpetual return on the incremental investment so that return on the
working capital during any period reflects an accumulation of the perpetual charge for the initial balance and for any subsequent investments in incremental amounts. There is
no maintenance investment reflected in the PFI.
Practical Expedient (Working Capital): To the extent that working capital is assumed to maintain a constant relationship with revenue, the incremental investments in working
capital will correlate with revenue growth. As the rate of return on each annual investment in working capital remains the same, the accumulation of the return on working
capital would also maintain a constant relationship with revenue. Therefore, calculating the initial return on the average balance of working capital and applying this CAC as a
percent of revenue in the future reasonably approximates the detailed calculation provided in the Comprehensive Example and Toolkit. Note that if there is a period during the
early years of the projection where the relationship between working capital and revenue is migrating towards a long-term normalized amount then this assumption should be
applied on a blended basis or for periods after which a normalized amount is achieved.
Fixed Assets: The CAC for fixed assets varies from that of working capital in that fixed assets (other than land) are assumed to deteriorate in value and a return of in addition to
the return on should be applied. The same underlying premise does hold; that the present value of the return on and return of is equal to the initial investment. Therefore, the
initial balance as well as future investments are replaced with a present value equivalent return of and return on . In the Comprehensive Example, the annual fixed asset
investments, which include both the replacement of fixed assets as well as incremental investment, are replaced with a return on and return of for each annual investment. The
maintenance investment is reflected in the PFI as a sub-set of the projected capital expenditures.
First Practical Expedient (Fixed Assets): If the simplifying assumptions stated in the introduction, regarding the effective tax rate and detailed waterfall approximation, are
appropriate, then a recalculation of the depreciation in the PFI would not be required. In addition, the adjustment to depreciation to arrive at the Adjusted Entity Value resulting
from any differences between the carrying value and the fair value of the fixed assets can be calculated directly. This is incorporated into the analysis by calculating the
increased (or decreased) depreciation related to the step-up (or step-down) of the fixed assets and reflected as an adjustment to the depreciation in the Entity Value PFI.
Second Practical Expedient (Fixed Assets): As with working capital, if it is reasonable to assume that the future level of fixed assets maintains a constant relationship with
revenue (that is, the fixed asset turnover remains relatively constant), then investments in fixed assets will provide for the maintenance of the prior year's balance as well as any
growth and the annual amounts will correlate with revenue growth (see Exhibit B-2a). As the rate of return on each annual investment in fixed assets remains the same, the
return on the average balance of fixed assets would also maintain a constant relationship with revenue. Therefore, calculating the initial return on the average balance of fixed
assets and applying this CAC as a percent of revenue in the future reasonably approximates the detailed calculations provided in the Comprehensive Example and Toolkit. Note
that if there is a period during the early years of the projection where the relationship between fixed assets and revenue is migrating towards a long-term normalized amount then
this assumption should be applied on a blended basis or for periods after which a normalized amount is achieved.
Third Practical Expedient (Fixed Assets): If it is assumed that projected depreciation in the PFI reflects the economic use of the fixed assets and the differences between tax
depreciation and accounting depreciation are captured in the effective tax rate, then the return of the fixed assets in the Average Annual Balance Technique would be equivalent
to accounting depreciation. The annual investment in fixed assets is excluded in excess earnings (the investment has been replaced by the CAC). Since the depreciation cash
flow adjustment equates to the return of the fixed assets these two adjustments to debt free net income offset each other. Therefore, a reasonable presentation would be to
exclude the depreciation cash flow adjustment, capital expenditure investment and the return of the fixed assets in the presentation of the excess earnings for the subject
intangible asset.
Assembled Workforce (or any intangible asset valued with the cost approach): These contributory assets are similar to fixed assets in that they provide economic benefit
beyond the period of the initial investment. However, the means by which the asset is maintained and increased is reflected as an expense rather than cash flow adjustment in
the income and cash flow statements. Fixed assets are capitalized and the tax benefit is realized through the deduction of depreciation expense in the future. AWF
investments are treated as an immediate expense for financial reporting and tax purposes. To the extent that the fair value of an AWF is based upon the pre-tax cost to create
the asset, any investment to increase the AWF would also be measured based on the pre-tax investment rather than an after tax investment. CACs are applied to the annual
balance of the fair value of the AWF. Therefore, just as with fixed assets, the investment (in this case, pre-tax expense) should be added back. Unlike fixed assets, the CAC is
limited to a return on the AWF because the return of the AWF is contained in the operating expenses to maintain the fair value.
First Practical Expedient (Assembled Workforce): As discussed in Section 3.7, the initial pre-tax investment to increase the AWF should be added back in the excess income
projection to avoid double counting the initial investment and the CAC. This adjustment can be simply calculated by applying the revenue growth rate to the beginning balance
of the AWF in any period. This adjustment is also consistent with the approach applied to incremental working capital where the annual investment in increased working capital
is removed from the excess earnings projection and is replaced with a return on the average annual balance.
Second Practical Expedient (Assembled Workforce): To the extent that the AWF is assumed to maintain a constant relationship with revenue (e.g. the revenue per employee
remains relatively constant) the incremental investments in the AWF will correlate with revenue growth. As the rate of return on each annual investment in the AWF remains the
same, the accumulation of the return on the AWF would also maintain a constant relationship with revenue. Therefore, calculating the initial return on the average balance of
the AWF and applying this CAC as a percent of revenue in the future reasonably approximates the detailed calculation provided in the Comprehensive Example and Toolkit.
Note that if there is a period during the early years of the projection where the relationship between the AWF and revenue is migrating towards a long-term normalized amount
then this assumption should be applied on a blended basis or for periods after which a normalized amount is achieved.
56
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Contributory Asset Charges
Exhibit B-4
The assumptions underlying the Comprehensive Example are consistent with the practical expedients discussed in Exhibit B-3. Working capital, fixed assets and the AWF
maintain a reasonably constant relationship to the revenue. Therefore the return on the aggregate of the contributory assets in the initial period can reasonably be carried
forward as a percent of revenue to apply the CACs. The following demonstrates one approach to these practical expedients.
Year 1
Revenue
Beginning Balance
add: Incremental Investment
less: Return Of (depreciation)
Ending Balance
Average Balance
30%
285
15
n/a
300
293
Mid-period Adjustment Factor
0.9535
Working Capital
Fixed Assets
Assembled Workforce
$
950
$
1,000
$
1,000
$
1,000
(1)
(2)
1,000
286
285
1,001
1,001
0.9535
(3)
(4)
200
11
-
211
206
0.9535
Return On (5)
3%
8
5%
48
10%
20
Percent of Revenue
Total Return On applied as a CAC
0.84%
7.57%
4.77%
1.96%
(1) Exhibit B-1.
(2) Exhibit B-2 includes incremental depreciation due to the fixed asset step-up.
(3) The percent increase in revenue ($50/$950 or 5.3%) applied to the initial fair value of $200, rounded.
(4) The return of is reflected in operating expenses as discussed in Exhibit B-3.
(5) After tax rates of return.
COPYRIGHT © 2010 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
57
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
Customer Relationships MPEEM: Practical Expedients
Exhibit B-5
Applies the practical expedients in the valuation of the customer relationships.
Total Revenue
$
1,000
$
1,050
$
1,165
$
1,306
$
1,456
$
1,596
$
1,718
$
1,823
$
1,907
$
1,976
$
2,035
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10 Residual
Customer Relationship Revenue (1)
Gross Profit
Operating Expenses:
Maintenance R&D (2)
R&D - Future IP (2)
Trade name advertising (3)
Current customer marketing (4)
Future customer marketing (5)
Total marketing
Total G&A
Total Operating Expenses
EBITDA
Adjusted Depreciation (6)
Amortization - AWF (7)
EBIT
less: Trade Name Royalty (8)
IP Royalty (8)
Adjusted EBIT
Taxes
Debt Free Net Income
add: Amortization - AWF (8)
AWF Growth Investment (9)
less: Return On Contributory Assets (10)
Excess Earnings
90%
0.0%
0.0%
0.0%
3%
7%
5%
10%
38%
900
810
-
-
-
27
-
27
63
90
720
257
18
445
45
90
310
119
191
18
10
68
151
855
770
-
-
-
26
-
26
60
86
684
244
16
424
43
86
295
113
182
16
9
65
142
770
693
-
-
-
23
-
23
54
77
616
212
13
391
39
77
275
106
169
13
16
58
140
616
554
-
-
-
18
-
18
43
61
493
164
9
320
31
62
227
87
140
9
14
47
116
431
388
-
-
-
13
-
13
30
43
345
112
6
227
22
43
162
62
100
6
9
33
82
259
233
-
-
-
-
8
8
18
26
207
67
3
137
13
26
98
38
60
3
5
20
48
130
117
-
-
-
-
4
4
9
13
104
34
2
68
7
13
48
18
30
2
2
10
24
65
59
33
30
-
-
-
-
2
2
5
7
52
17
1
34
3
7
24
9
15
1
1
5
12
-
-
-
-
1
1
2
3
27
9
-
18
2
3
13
5
8
-
-
2
6
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
PV Factor (11)
10%
0.9535
0.8668
0.7880
0.7164
0.6512
0.5920
0.5382
0.4893
0.4448
0.4044
0.4044
PV Excess Earnings
Total PV Excess Earnings
Tax Amortization Benefit (12)
Fair Value - Customer Relationships
Fair Value - Comprehensive Example (13)
144
563
152
715
719
123
110
83
53
28
13
6
3
-
-
(1) Assumed to decline over a 9 year period. Therefore, calculations only continue for those 9 years.
(2) Maintenance and future R&D is assumed to be included in the 10% IP royalty rate (licensor responsible for all R&D in the future) and is therefore removed in the excess
earnings. The R&D expenses would be reflected as a reduction to the royalty in the valuation of the IP. Alternately, it might be determined that the royalty rate is stated
net of the R&D expenses in which case the R&D expenses would remain in the excess earnings.
(3) Advertising expenses removed under the same assumptions provided in footnote 2.
(4) Maintenance marketing expenses specific to current recognizable customer relationships.
(5) Marketing expenses related to creating and maintaining unrecognized and future customer relationships are excluded.
(6) Exhibit B-2 amounts allocated in proportion to revenue.
(7) Exhibit B-2 amounts allocated in proportion to revenue. The amortization of the initial assembled workforce differs from the return of reflected in the operating expenses.
This is due to the tax treatment of recapturing the amortizable tax basis that has been expensed historically that would occur in a taxable transaction.
(8) Royalty rates assumed to be gross (e.g., inclusive of advertising and R&D expenses). The same rates would be incorporated in the valuation of the trade name and IP.
Note that the royalty charge is applicable to both current and future contributory assets (see paragraphs 3.6.02 - 3.6.04).
(9) Exhibit A-7 annual growth investment amounts allocated in proportion to revenue (from Comprehensive Example).
(10) Exhibit B-4 percentage applied to revenue.
(11) Discount rate assumed to be equivalent to the IRR/WACC and a mid-period convention.
(12) Based on a 15 year straight-line amortization period, 40% tax rate and a 10% discount rate using a mid-period convention.
(13) See Exhibit A-8. Comparison is made to the Average Annual Balance technique.
58
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Appendix C: Pre-tax versus After-tax Adjustments for Growth Investments in Certain Intangible Assets
This Appendix relates only to the topic discussed in Section 3.7. It is intended to address why the add-back of the growth investment in assembled workforce
(or other intangible assets valued using a cost approach or other approach when the expenditure is viewed as a period expense) should be equal to the pre-
tax growth investment and not an after-tax amount (assuming the acquired or current assembled workforce was valued using pre-tax cost).
The overall PFI includes future investment to maintain as well as increase the assembled workforce, reflected in the projected cost structure of the business
and in the entity value. In the context of an MPEEM used to value a subject intangible asset (such as customer relationships), a CAC or return on the
assembled workforce will be introduced into the analysis. As indicated elsewhere in this document, investments in assets have utility beyond the period of
the cash charge. CACs capture this future utility by replacing the cash charges with a series of charges over the economic life of the asset, as represented by
the required return of and return on the fair value of the necessary level of contributory asset. The following paragraphs address only the return on portion
of the CAC because the return of portion is present in the operating expenses of the entity and is not the subject of this Appendix.
If the acquired or current assembled workforce has a fair value of $100 and the return on is 10%, then the annual CAC would be $10. This return on
carries on into perpetuity (the acquired or current assembled workforce balance is maintained in the expenses). The present value of the return on is $100
($10/10%) so the cash flow available to other intangible assets (including goodwill) is reduced by $10 annually in the form of a CAC, or $100 in present
value terms.
Similarly, in the MPEEM used to value a subject intangible asset, CACs related to future assembled workforce investments equate to replacing a growth
investment with a perpetual return on (the growth investment is replaced with the CAC on that growth). In calculating the CAC, the fair value of the
assembled workforce is reflected as having increased by the pre-tax growth investment (see Exhibit A-7 of Appendix A). Therefore, to ensure that the cash
flow attributable to the subject intangible asset is not “over-charged” for the contribution of the assembled workforce, the add-back to the analysis has to
be on a pre-tax basis.
Following is an example that looks at year one of the cash flows used in an MPEEM to value customer relationships. The example assumes a $20 growth
investment in assembled workforce in year one. For purposes of this example, assume there are no other assets. This simple example shows that value is
neither created nor destroyed by equating the MPEEM cash flow attributable to customer relationships to the cash flow used in the entity discounted cash flow.
COPYRIGHT © 2010 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
59
BEST PRACTICES FOR VALUATIONS IN FINANCIAL REPORTING – CONTRIBUTORY ASSETS
Effect of assembled workforce (AWF) growth investment on the cash flow used in the entity value discounted cash flow:
Year One Pre-tax growth investment in AWF
Tax at 40%
After-tax investment*
*Appears in Entity Value discounted cash flow
$(20)
8
(12)
Effect of assembled workforce (AWF) growth investment on the cash flow used in the customer relationship MPEEM:
In MPEEM, the above after-tax investment effect still appears:
After-tax investment
And the growth investment is replaced with the CAC:
CAC on $20 increased “value”, at 10% = $2 annually
Year One PV of perpetual $2 CAC at 10% = $20
Add back growth investment at $20 pre-tax amount
Net reduction in cash flow available for customer relationships
(12)
(20)
20
$(12)
These calculations simply demonstrate that the cash flow effect in the entity value ($12) equals the cash flow effect on customer relationship
value in the MPEEM ($12). No value created or destroyed.
60
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61
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www.appraisalfoundation.org
0810WEB
FEBRUARY 2019
VALUATIONS IN FINANCIAL
REPORTING VALUATION ADVISORY 4:
VALUATION OF CONTINGENT
CONSIDERATION
COPYRIGHT © 2019 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED.
VFR Valuation Advisory #4
Valuation of Contingent Consideration
This communication is for the purpose of issuing voluntary guidance on recognized valuation
methods and techniques.
Date Issued: February 14, 2019
Application: Business Valuation
Summary: When negotiating the purchase price of a business, contingent consideration is often
used to bridge the price gap between what the seller would like to receive and what the buyer
would like to pay. More generally, a portion of the purchase consideration may be contingent on
the outcome of future events. For example, additional consideration may be paid if the acquired
business meets certain targets (such as future revenue, margin, or profit targets), passes regulatory
reviews, has successful litigation outcomes, meets covenants, or completes product development.
The valuation of contingent consideration is inherently challenging due to dependence on the
occurrence of future events and the often complex structure of the payoff functions. It has also
been an area for which limited guidance exists, therefore making it a suitable topic for an
undertaking such as this one.
Valuation specialists strive to provide reasonably consistent and supportable fair value
conclusions. To this end, it is believed that guidance regarding best practices on certain specific
valuation topics would be helpful. The Appraisal Foundation selects topics based on those in
which the greatest diversity of practice has been observed. To date, The Appraisal Foundation
has issued three prior Valuations in Financial Reporting (VFR) Advisories as follows: VFR
Advisory #1, The Identification of Contributory Assets and Calculation of Economic Rents (May
31, 2010); VFR Advisory #2, The Valuation of Customer Related Assets (June 15, 2016), and
VFR Advisory #3, The Measurement and Application of Market Participant Acquisition
Premiums (September 6, 2017).
The Appraisal Foundation wishes to express its utmost gratitude to the Working Group on
Valuation of Contingent Consideration for volunteering their time and expertise in contributing
to this Advisory. Specifically, sincere thanks to the following individuals:
Working Group on Valuation of Contingent Consideration
Travis Chamberlain
CliftonLarsonAllen, LLP – Indianapolis, IN
Ron Elkounovitch
Ernst & Young, LLP – Atlanta, GA
Lawrence J. Freundlich
KPMG LLP – New York, NY
Tanuj Leekha
PricewaterhouseCoopers, LLP – New
York, NY
Alok Mahajan (Chair)
KPMG LLP - Santa Clara, CA
Sorin Maruster
KPMG LLP – Santa Clara, CA
William A. Johnston
Empire Valuation Consultants, LLC – New
York, NY
Gary J. Raichart
Duff & Phelps, LLC - East Palo Alto, CA
Daniel Kahn
Ernst & Young, LLP – Washington, DC
Lynne J. Weber
Duff & Phelps, LLC – East Palo Alto, CA
Appraisal Practices Board Liaisons
Adriana Berrocal, Galaz, Yamazaki, Ruiz Urquiza, S.C. (Deloitte)
Jay E. Fishman, Financial Research Associates
The Appraisal Foundation Staff
David Bunton, President
John S. Brenan, Vice President of Appraisal Issues
Appraisal Practices Board Members (2016-2017)
Shawn Wilson, Chair
Lisa Desmarais, Vice Chair
Adriana Berrocal
Greg Franceschi
Ernest Durbin
Donna VanderVries
The views set forth in this Advisory are the collective views of the members of this Working Group
and do not necessarily reflect the views of any of the firms that the Working Group members are
associated with.
This Advisory was approved for publication by the Board of Trustees of The Appraisal Foundation
on February 14, 2019. The reader is informed that the Board of Trustees defers to the members of
the Working Group for expertise concerning the technical content of the document.
Valuation of Contingent Consideration
Table of Contents
SECTION 1: INTRODUCTION.......................................................................................................................................... 6
1.1 SCOPE ....................................................................................................................................................................... 6
1.2
INTENDED USERS ......................................................................................................................................................... 7
1.3 MOTIVATIONS FOR STRUCTURING CONTINGENT CONSIDERATION ......................................................................................... 7
1.4 MOTIVATION FOR PROVIDING A GUIDE FOR THE VALUATION OF CONTINGENT CONSIDERATION .................................................. 8
1.5 RECOMMENDATIONS FOR CONTINGENT CONSIDERATION VALUATION METHODS ..................................................................... 8
SECTION 2: ACCOUNTING BACKGROUND ................................................................................................................... 11
2.1 CONSIDERATION TRANSFERRED IN BUSINESS COMBINATIONS ............................................................................................. 11
2.2 FAIR VALUE CONCEPTS ............................................................................................................................................... 12
SECTION 3: CHARACTERIZING CONTINGENT CONSIDERATION ................................................................................... 14
3.1 UNDERLYING METRIC(S) ............................................................................................................................................. 14
3.2 CONTINGENT CONSIDERATION PAYOFF STRUCTURES ........................................................................................................ 15
Common Contingent Consideration Payoff Structures ........................................................................... 15
Path Dependency ................................................................................................................................... 17
Multiple Underlying Metrics or Multiple Forms of Settlement ............................................................... 17
Buyer or Seller Choices ........................................................................................................................... 18
Currency ................................................................................................................................................. 18
3.3 SETTLEMENT TYPES FOR CONTINGENT CONSIDERATION .................................................................................................... 18
3.2.1
3.2.2
3.2.3
3.2.4
3.2.5
SECTION 4: KEY VALUATION CONCEPTS RELATED TO EARNOUTS ............................................................................... 20
4.1 MARKET PARTICIPANT ASSUMPTIONS ............................................................................................................................ 20
4.2 PROBABILISTIC FORECASTS AND EXPECTED VALUES .......................................................................................................... 21
4.3 DIVERSIFIABLE AND NON-DIVERSIFIABLE RISK ................................................................................................................. 23
Capital Asset Pricing Model Framework for Quantifying Non-Diversifiable Risk ................................... 24
4.4 THE RISK ASSOCIATED WITH THE CONTINGENT CONSIDERATION PAYOFF STRUCTURE .............................................................. 27
4.5 THE IMPACT OF PAYOFF STRUCTURE ON RISK: THE ANALOGY TO LEVERAGE .......................................................................... 30
4.6 RISK-NEUTRAL VALUATION ......................................................................................................................................... 32
4.3.1
SECTION 5: VALUATION METHODOLOGIES................................................................................................................. 36
5.2.1
5.2.2
5.2.3
5.2.4
5.2.5
5.2.6
5.2.7
5.1 VALUATION APPROACHES: INCOME APPROACH, MARKET APPROACH AND COST APPROACH .................................................... 36
5.2 KEY ELEMENTS OF AN INCOME APPROACH TO CONTINGENT CONSIDERATION VALUATION ....................................................... 37
Estimating Contingent Consideration Payment Cash Flows ................................................................... 37
Discount Rate and Market Risk Considerations ..................................................................................... 39
Methods for Estimating the Required Metric Risk Premium .................................................................. 43
Estimating Volatility ............................................................................................................................... 55
In-Period Discounting Convention .......................................................................................................... 60
Counterparty Credit Risk ........................................................................................................................ 62
Multiple-currency Structures .................................................................................................................. 63
5.3 THE SCENARIO-BASED METHOD (SBM) ........................................................................................................................ 65
When the SBM is Most Appropriate ....................................................................................................... 65
Developing the Scenarios ....................................................................................................................... 67
Discount Rate Considerations ................................................................................................................. 67
Applying the SBM to a Linear Payoff Structure ...................................................................................... 68
Applying the SBM to a Diversifiable Nonfinancial Milestone ................................................................. 70
Using Simulation to Handle Path Dependency or Multiple Interdependent Metrics in SBM.................. 70
Conclusions Regarding SBM ................................................................................................................... 71
5.3.1
5.3.2
5.3.3
5.3.4
5.3.5
5.3.6
5.3.7
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5.4.1
5.4.2
5.4.3
5.4.4
5.4.5
5.4.6
5.4 THE OPTION PRICING METHOD (OPM) ......................................................................................................................... 71
When the OPM is Most Appropriate ...................................................................................................... 72
OPM Implementation in the Risk-Neutral Framework ........................................................................... 72
Using OPM When the Metric Distribution is Not Lognormal ................................................................. 73
Using Simulation to Handle Path Dependency or Multiple Interdependent Metrics in an OPM ............ 74
Using a Binomial Lattice to Handle Buyer or Seller Choices ................................................................... 75
Conclusions Regarding OPM .................................................................................................................. 76
5.5 COMPARISON OF SBM VERSUS OPM ........................................................................................................................... 76
Advantages and Disadvantages of the SBM .......................................................................................... 77
Advantages and Disadvantages of the OPM .......................................................................................... 78
5.6 SUMMARY OF KEY RECOMMENDATIONS REGARDING THE VALUATION OF CONTINGENT CONSIDERATION .................................... 79
5.5.1
5.5.2
SECTION 6: CLAWBACKS ............................................................................................................................................. 81
6.1 UNDERLYING METRICS FOR CLAWBACKS ........................................................................................................................ 81
6.2 THE IMPACT OF THE PAYOFF STRUCTURE OF CLAWBACKS ON THE DISCOUNT RATE ................................................................. 81
6.3 COUNTERPARTY CREDIT RISK FOR CLAWBACKS ................................................................................................................ 82
SECTION 7: ASSESSING THE REASONABILITY OF A CONTINGENT CONSIDERATION VALUATION ................................. 83
7.1 CONSISTENCY OF THE EARNOUT METRIC FORECAST IN SINGLE VS. MULTI-SCENARIO VALUATION .............................................. 83
7.2 CONSISTENCY WITH VALUATION OF THE BUSINESS, THE INTANGIBLES, AND IPR&D ................................................................ 84
7.3 CONSISTENCY WITH THE RATIONALE FOR INCLUDING CONTINGENT CONSIDERATION IN THE TRANSACTION .................................. 88
7.4 CONSISTENCY WITH HISTORICAL AND MARKET DATA ........................................................................................................ 88
7.5 REASONABLENESS OF THE TOTAL PURCHASE CONSIDERATION AND IRR ................................................................................ 89
SECTION 8: UPDATING CONTINGENT CONSIDERATION VALUATION .......................................................................... 91
8.1 VALUATION METHODOLOGY FOR UPDATING THE FAIR VALUE OF CONTINGENT CONSIDERATION ............................................... 91
8.2 UPDATING THE VALUATION INPUTS ............................................................................................................................... 91
Actual Results Related to the Earnout Metric ........................................................................................ 91
Updated Forecast for the Earnout Metric .............................................................................................. 92
Updated Discount Rate and Volatility for the Earnout Metric ............................................................... 92
Updated Counterparty Credit Risk .......................................................................................................... 93
8.2.1
8.2.2
8.2.3
8.2.4
SECTION 9: EXAMPLES OF VALUATION OF COMMON CONTINGENT CONSIDERATION PAYOFF STRUCTURES ............. 94
9.1 EXAMPLE: LINEAR PAYOFF STRUCTURE (EBITDA) ........................................................................................................... 94
9.2 EXAMPLE: LINEAR PAYOFF STRUCTURE (REVENUE) .......................................................................................................... 95
9.3 EXAMPLE: TECHNICAL MILESTONE (DIVERSIFIABLE BINARY) STRUCTURE .............................................................................. 96
9.4 EXAMPLE: FINANCIAL MILESTONE (SYSTEMATIC BINARY) STRUCTURE .................................................................................. 96
9.5 EXAMPLE: THRESHOLD (CALL OPTION) STRUCTURE .......................................................................................................... 97
9.6 EXAMPLE: PERCENTAGE OF TOTAL ABOVE A THRESHOLD (ASSET-OR-NOTHING) STRUCTURE .................................................... 98
9.7 EXAMPLE: THRESHOLD AND CAP (CAPPED CALL) STRUCTURE ............................................................................................. 99
9.8 EXAMPLE: TIERED PAYOFF STRUCTURE ........................................................................................................................ 100
9.9 EXAMPLE: MULTI-YEAR, NOT PATH DEPENDENT (SERIES OF CAPPED CALLS) ....................................................................... 101
9.10 EXAMPLE: MULTI-YEAR, PATH DEPENDENT (CAPPED CALL SERIES WITH A CATCH-UP FEATURE) ............................................. 102
9.11 EXAMPLE: CLAWBACK (PUT OPTION STRUCTURE) .......................................................................................................... 105
SECTION 10: APPENDIX ............................................................................................................................................ 106
10.1 FREQUENTLY ASKED QUESTIONS................................................................................................................................. 106
10.2 GLOSSARY .............................................................................................................................................................. 111
10.3 TECHNICAL NOTES ................................................................................................................................................... 118
Estimating Earnings-Based RMRPs by De-Levering for Financial Leverage ......................................... 119
Estimating Revenue-Based RMRPs by De-Levering EBIT RMRPs for Operational Leverage ................. 122
The Bottom-Up Method for Estimating a RMRP for Any Metric .......................................................... 125
Two Methods for Risk-Adjusting the Metric Forecast .......................................................................... 126
The Applicability of the Normal Distribution to Financial Metrics ....................................................... 128
10.3.1
10.3.2
10.3.3
10.3.4
10.3.5
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10.3.6
10.3.7
Characteristics of a Geometric Brownian Motion, Extensions and Alternatives .................................. 129
Academic Support for Use of OPM for Non-Traded Financial Metrics ................................................. 130
10.4 REFERENCES ........................................................................................................................................................... 131
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Section 1: Introduction
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This document (Valuation in Financial Reporting Advisory #4, hereinafter referred to as the Valuation
Advisory), entitled Valuation of Contingent Consideration, is the result of deliberations by the
Working Group on Contingent Consideration (the fourth Working Group in the “Best Practices for
Valuations in Financial Reporting: Intangible Asset Working Group” series) and was developed with
input received from interested parties.
As part of the initial recognition and measurement requirements under Financial Accounting Standards
Board (FASB) Accounting Standards Codification (ASC) Topic 805 – Business Combinations (ASC
805) and International Financial Reporting Standards (IFRS) Standard 3 Business Combinations
(Revised) (IFRS 3R), contingent consideration included in a business combination must be measured
at fair value as of the acquisition date. The purpose of this Valuation Advisory is to outline best
practices in the valuation of contingent consideration for financial reporting purposes pursuant to ASC
805 and IFRS 3R. While there may be differences in the accounting related to contingent consideration
under ASC 805 and IFRS 3R, the valuation principles for estimating the fair value of contingent
consideration described in this Valuation Advisory are the same. The guidance in this document may
also be applicable to estimating the fair value of contingent consideration for other purposes, including
FASB ASC Topic 946 Financial Services—Investment Companies (ASC 946), as will be discussed
in Section 2.
This Valuation Advisory is not intended to provide guidance on the accounting for contingent
consideration. References to accounting concepts or rules used to provide context within this
Valuation Advisory are specific to United States Generally Accepted Accounting Principles (U.S.
GAAP), unless noted otherwise.
ASC 805 and IFRS 3R define contingent consideration as usually being an obligation of the acquirer
to transfer additional assets or equity interests to the former owners of the acquiree as part of the
exchange for control of the acquiree if specified future events occur or conditions are met (an
“earnout”). However, contingent consideration also may give the acquirer the right to claw back
previously transferred consideration if specified conditions are met (a “clawback”).
1.1
Scope
The following discussion on the valuation of contingent consideration for financial reporting purposes
requires an understanding of relevant accounting and valuation concepts. In-depth discussion of these
concepts is beyond the scope of this Valuation Advisory and the reader is assumed to have a general
understanding of these concepts. Specifically, the reader is assumed to have knowledge of relevant
accounting and valuation concepts as they relate to the valuation of assets and liabilities for financial
reporting purposes.
The Working Group recognizes professional judgment is critical in effectively planning, performing,
and concluding a valuation. Professional judgment requires a process of fact-gathering, research, and
analysis to reach well-reasoned conclusions based on relevant facts and circumstances available at the
measurement date. Due to the nature of judgments, questioning and skepticism are appropriate. Even
then, knowledgeable, reasonable, objective individuals can reach different conclusions for a given set
of facts and circumstances.
The following important clarifications regarding this document are also made:
a) These best practices have been developed with reference to U.S. GAAP and IFRS effective as
of the date this document was published. While the Working Group believes the best practices
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described herein may have application outside of U.S. GAAP and IFRS, valuation specialists
should not apply these best practices to valuations prepared under different standards/statutory
requirements without a thorough understanding of the differences between those standards and
U.S. GAAP and IFRS existing as of the date of this publication.
b) The discussions and examples in this Valuation Advisory make specific assumptions for
illustrative purposes only. While general principles have been provided for guidance to assist
in the valuation of contingent consideration, assumptions used in the valuation of any asset or
liability should be based on situation-specific facts and circumstances.
c) The models used in the sample calculations are for illustrative purposes only and are not
intended to represent the only form of model, calculation, or final report exhibit that is
generally considered acceptable among valuation specialists.
d) The methods discussed in this Valuation Advisory are not intended to represent an exhaustive
list; additional methods exist and may be developed in the future.
This document provides guidance related to valuation techniques that are used to value contingent
consideration and includes detailed discussion of the following topics:
a) Fair value of contingent consideration and relevant concepts
b) Identification of typical structures of contingent consideration and key valuation issues
c) Valuation methodologies used to estimate the fair value of contingent consideration that are
viewed to be representative of best practice, including
(1) Strengths and weaknesses of each methodology
(2) Applicability of methods
(3) Practical solutions or alternatives where appropriate
d) Methods for assessing the reasonableness of contingent consideration fair value estimates
e) Additional considerations related to any updates of the fair value of contingent consideration
at subsequent measurement dates.
This Valuation Advisory include examples of several techniques relevant to the valuation of
contingent consideration. Each example provides a set of facts and circumstances to demonstrate the
associated valuation techniques discussed.
1.2
Intended Users
The intended users of this document are financial statement issuers, valuation specialists, auditors, and
other interested parties.
1.3 Motivations for Structuring Contingent Consideration
As part of a business combination, companies may structure a portion of the purchase consideration
contingent on the future performance of the acquired business or post-acquisition events. Contingent
consideration can arise out of transaction negotiations for many reasons, including:
• Bridging the valuation gap – The buyer and seller may have differences of opinion regarding
the outlook and associated risks for the acquired business or regarding the likelihood of certain
post-acquisition events. The buyer may be unwilling to pay for value perceived by the seller’s
typically more optimistic outlook. This gap can be bridged by agreeing on an upfront price
consistent with the buyer’s perception of the outlook and risk, while providing for a contingent
payment in the future if the seller’s more optimistic outlook is achieved.
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• Alternative financing – The buyer and seller could use contingent consideration to defer a
portion of the purchase consideration to a later date when the buyer will have greater financial
ability to pay as the business performs.
Incentive for management – If the sellers have the opportunity to remain involved with or help
contribute to the future success of the business, contingent consideration can be used to help
incentivize and motivate the sellers to help the business meet certain targets.
•
• Sharing of risk and reward – Contingent consideration, whether an earnout or clawback, can
provide a mechanism for the buyer and seller to shift and allocate risk by enabling the seller to
share in the risk and reward related to future performance.
According to studies in recent years, the percentage of deals for private company targets that include
contingent consideration is in the range of 19% to 38%, but can reach as high as 75% in industries
such as biotech and pharmaceuticals.1
1.4 Motivation for Providing a Guide for the Valuation of Contingent Consideration
Valuation of contingent consideration can be challenging. Contingent consideration assets or liabilities
are rarely traded and contingent consideration structures are often unique, making finding comparable
traded assets or liabilities impractical. Contingent consideration is often related to the cash flows of
the business, but the typical option-like, leveraged structures make it difficult to assess the appropriate
discount rate to properly account for the risk of the contingent payments.
As a result, valuation of contingent consideration has been a subject of significant diversity in practice.
Some valuation specialists use a simple probability-weighted methodology, but are not able to offer
good support for what discount rate to use. Others use option-based models, which may be considered
complex, lacking in transparency or difficult to understand.
The Working Group has explored various types of prevailing valuation methodologies and analyzed
the strengths and weaknesses of each. In the process, we have gained an appreciation for the
complexity of the issues surrounding contingent consideration valuation and a deeper understanding
of how fundamental valuation principles should affect the choice and implementation of valuation
methodology for contingent consideration.
1.5
Recommendations for Contingent Consideration Valuation Methods
For valuing contingent consideration, the market approach is rarely used due to the lack of an active
trading market that provides reliable indications of value. The cost approach is also typically not
appropriate, since typically there is no obvious way to estimate a replacement cost and the cost
approach does not consider future expectations. The Working Group has observed two income
approach methods for valuing contingent consideration commonly used by valuation specialists:
•
In the Scenario-Based Method (SBM, see Section 5.3), the valuation specialist identifies
multiple outcomes, probability weights these outcomes to arrive at an expected payoff cash
flow, and discounts the expected payoff cash flow at an appropriate rate. The SBM discount
rate addresses the time value of money (risk-free rate) over the relevant time horizon, Required
Metric Risk Premium,2 the contingent consideration payoff structure, and any counterparty
credit risk.
1 See the American Bar Association’s 2017 Private Target Deal Points Study, SRS Acquiom’s 2018 M&A Deal Terms Study, and
Houlihan Lokey’s 2014 Purchase Price Allocation Study.
2 A “metric” is a quantifiable measurement unit or an event defined in the contingent consideration agreement, the value or occurrence
of which will affect the amount of the contingent consideration to be paid (see Section 3.1). The Required Metric Risk Premium is a
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•
In the Option Pricing Method (OPM, see Section 5.4), the valuation specialist applies an
appropriate discount rate to the relevant forecast in order to establish a risk-neutral forecast
distribution for the metric underlying the contingent consideration, estimates the expected
payoff cash flow in this risk-neutral framework, and then discounts the risk-neutral expected
payoff cash flow at the risk-free rate over the relevant time horizon, adjusted for any
counterparty credit risk.
Other methods also may exist or be developed in the future.
No single method for valuing contingent consideration appears to be superior in all respects and
circumstances. Each method has merits and challenges, the methods differ in level of complexity, and
there are trade-offs in selecting one method over the other.
However, the Working Group has concluded that there are contingent consideration types for which
each of these income approach methods is typically most appropriate. As described in more detail in
the remainder of this Valuation Advisory, the Working Group recommends the following to select a
method for valuing contingent consideration:
a) If the risk of the underlying metric is diversifiable (see Section 4.3), e.g., achievement of a
product development milestone, choose SBM
b) If the payoff structure is linear (e.g., a fixed percentage of revenues or earnings before interest,
tax, depreciation, and amortization (EBITDA) with no thresholds, caps, or tiers, see Section
3.2.1), choose SBM
c) If the risk of the underlying metric is non-diversifiable and the payoff structure has thresholds,
caps, tiers, or other nonlinearities, choose OPM
d) If the payoff structure is path dependent (e.g., a carry-forward feature, a catch-up provision or
a multi-year cap) or is based on multiple interdependent metrics (see Sections 3.2.2 and 3.2.3),
choose SBM or OPM as recommended above, using a technique that can handle these
complexities (such as Monte Carlo simulation).
The Working Group does not recommend the use of SBM for nonlinear payoff structures involving a
metric with non-diversifiable risk. In this situation, the SBM discount rate would have to be adjusted
to account for the impact of the nonlinear payoff structure. However, the magnitude of the discount
rate adjustment cannot be easily intuited and the Working Group is not aware of any reasonable “rules
of thumb” for developing such adjustments. It is for this reason that OPM is recommended over SBM
in this situation.
Whether applied to the expected payoff cash flow (as in SBM) or to create a risk-neutral expected
payoff cash flow (as in OPM), the discount rate should incorporate a risk premium associated with
and appropriate to the underlying metric for the contingent consideration. The Required Metric Risk
Premium will often differ from the risk premium used to value the associated business, due to
differences in risk between the underlying metric (such as revenue or EBITDA) and the long-term free
cash flows of the business. For example, the long-term free cash flows of the business are generally
riskier than revenues, due to a difference in leverage. Thus, even for a linear payoff structure, the
contingent consideration discount rate will often differ from the weighted average cost of capital
(WACC) and from the transaction internal rate of return (IRR).
measure of the excess return above the risk-free rate, or risk premium, that investors would demand to bear the non-diversifiable risk
associated with an investment in the metric over the duration of the earnout, as discussed in Section 5.2.2.
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The valuation of contingent consideration considers the value from the perspective of a market
participant in a hypothetical sale or transfer of a contingent consideration asset (or liability) on a
standalone basis post-transaction, i.e., separate from the related business and with the related business
under the new ownership of the actual buyer. For this reason, no matter which valuation methodology
is selected, all synergies relevant to the calculation of the payoff, including buyer-specific synergies,
are generally included in the financial projections for the contingent consideration valuation.3
The remainder of this Valuation Advisory provides background information, key concepts, reasons
for the recommendations above, additional and more detailed implementation recommendations, and
examples and illustrations.
3 Buyer-specific synergies are included unless excluded from or irrelevant to the definition of the metric underlying the contingent
consideration.
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Section 2: Accounting Background
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2.1
Consideration Transferred in Business Combinations
From the acquirer’s perspective in a business combination, ASC 805 and IFRS 3R require the
recognition and measurement of the fair value (with limited exceptions) of identifiable assets acquired
(including financial assets, fixed assets, intangible assets, and contingent assets), liabilities assumed
(including financial liabilities and contingent liabilities), any consideration transferred, and any
noncontrolling interest and/or previously held equity interest in the acquiree. The consideration
transferred includes contingent consideration, which is required to be measured at fair value on the
acquisition date. As mentioned previously, while the valuation principles for estimating the fair value
of contingent consideration should be the same, there are differences between U.S. GAAP and IFRS
regarding under what circumstances contingent consideration must be measured at fair value. For
example, the guidance in ASC 805 and IFRS 3R require an acquirer to classify contingent
consideration as an asset, a liability, or equity based on U.S. GAAP or IFRS, respectively. Differences
in the related U.S. GAAP or IFRS might cause differences in the initial classification and, therefore,
might cause differences in the subsequent accounting. Discussion of these accounting differences is
beyond the scope of this document.
Furthermore, while the details of the acquirer’s accounting classification of contingent consideration
is beyond the scope of this document, for financial reporting purposes under U.S. GAAP a contingent
consideration arrangement that requires payment from the buyer to the seller in cash or assets will
generally result in classification as a liability, while settlement required in the acquirer’s shares may
be classified as either a liability or as equity depending on the structure of the arrangement. Similarly,
a contingent consideration arrangement that requires payment from the seller to the buyer in cash or
assets will generally result in an asset classification.
From the seller’s perspective, estimating the fair value of contingent consideration may also be
necessary for financial reporting purposes. For instance, pursuant to ASC 946, an investment company
may be required to estimate the fair value of assets it holds related to contractual rights arising from
contingent consideration arrangements. Similarly, if a non-investment company sells an investment
and contingent consideration is part of the structure, the company may also need to determine the fair
value of the contingent consideration. Note that the seller’s accounting for contingent consideration
and determining whether it will be measured at fair value at initial recognition and at subsequent
reporting dates is beyond the scope of this Valuation Advisory.
It should be noted that contingent payments in a business combination sometimes have characteristics
(such as being contingent on an employee’s continued employment) that might imply that the
payments are compensatory for post-combination services. Depending on facts and circumstances,
such payments may be accounted for as post-combination employment compensation expense and not
as part of the consideration transferred in the business combination. The specific accounting rules for
determining whether a contingent payment is considered compensation expense or contingent
consideration to be included in the consideration transferred are beyond the scope of this Valuation
Advisory.
It is common for a portion of the purchase price in a business combination to be held in escrow to
cover items such as working capital adjustments or possible payments related to the seller’s
satisfaction of representations and warranties. The specific accounting rules for determining whether
an escrow payment is contingent consideration are beyond the scope of this guide. However, given
that the definition of contingent consideration is an obligation to make a payment “if specified future
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events occur or conditions are met,” then if the release of the escrow payment is contingent on whether
specified future events occur or conditions are met, the escrow payment may be considered contingent
consideration. On the other hand, if the release of the escrow payment is contingent on verifying
conditions that existed at the acquisition date, generally, the escrow payment would not be considered
contingent consideration. Although typically escrow payments for general representations and
warranties and working capital adjustments fall into the latter category and are not considered to be
contingent consideration, the specific terms of the agreement should be reviewed before making such
a determination.
2.2
Fair Value Concepts
ASC 820 and IFRS 13 define fair value as the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the measurement date.
These standards also provide a framework for developing fair value measurements. A fair value
measurement assumes that the asset or liability is exchanged in an orderly transaction between market
participants to sell the asset or transfer the liability at the measurement date under current market
conditions. According to ASC 820 and IFRS 13:
• An orderly transaction is a transaction that assumes exposure to the market for a period prior
to the measurement dates to allow for marketing activities that are usual and customary for
transactions involving such assets or liabilities; it is not a forced transaction (for example, a
forced liquidation or distressed sale).
• The transaction to sell the asset or transfer the liability is a hypothetical transaction at the
measurement date, considered from the perspective of a market participant that holds the asset
or owes the liability.
Therefore, the objective of a fair value measurement is to estimate the price at which an orderly
transaction would take place between market participants under the market conditions that exist at the
measurement date.
While contingent consideration typically represents an obligation of the acquirer, it is appropriate to
think about valuing the contingent consideration based on the value of the corresponding asset. This
is supported by the following guidance:
• ASC 820-10-35-16B states, “When a quoted price for the transfer of an identical or a similar
liability or instrument classified in a reporting entity’s shareholders’ equity is not available and
the identical item is held by another party as an asset, a reporting entity shall measure the fair
value of the liability or equity instrument from the perspective of a market participant that
holds the identical item as an asset at the measurement date.”4
• ASC 820-10-35-16BB states, “In such cases, a reporting entity shall measure the fair value of
the liability or equity instrument as follows:
a) Using the quoted price in an active market for the identical item held by another party
as an asset, if that price is available
b) If that price is not available, using other observable inputs, such as the quoted price in
a market that is not active for the identical item held by another party as an asset
c) If the observable prices in (a) and (b) are not available, using another valuation
technique, such as:
4 Similar guidance is provided in IFRS 13:37.
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(1) An income approach (for example, a present value technique that takes into account
the future cash flows that a market participant would expect to receive from holding
the liability or equity instrument as an asset; see paragraph 820-10-55-3F)
(2) A market approach (for example, using quoted market prices for similar liabilities
or instruments classified as shareholders’ equity held by other parties as assets; see
paragraph 820-10-55-3A).”5
Below is a list of additional considerations pursuant to this fair value framework:
• Fair value hierarchy and level of inputs – ASC 820 and IFRS 13 provide a hierarchy of inputs
to be used in fair value measurements. Available observable inputs should be prioritized over
unobservable inputs. Level 3 inputs are unobservable inputs, which can include assumptions
related to prospective financial information, probabilities of events occurring, and estimated
volatility. Given the lack of quoted prices for identical or similar types of arrangements, the
fair value measurement of contingent consideration will likely involve a significant number of
Level 3 inputs.
• Unit of account – The unit of account is the level at which the asset or liability is aggregated
or disaggregated for recognition purposes. Contingent consideration arrangements with
multiple elements may be determined to be a single unit of account or multiple units of account
depending on facts and circumstances, and such determination may require significant
professional judgment. Guidance on the application of this accounting concept to contingent
consideration arrangements is beyond the scope of this Valuation Advisory.
• Principal and most advantageous market – Typically, there will be no observable or principal
market for the contingent consideration arrangement; thus, the reporting entity will need to
identify a most likely market based on assumptions that would be made by market participants
(i.e. the most advantageous market).
• Market participants – According to ASC 820 and IFRS 13, market participants are:
a) Independent of each other (that is, they are not related parties)
b) Knowledgeable, having a reasonable understanding about the asset or liability and the
transaction using all available information, including information that might be obtained
through due diligence efforts that are usual and customary
c) Able to enter into a transaction for the asset or liability
d) Willing to enter into a transaction for the asset or liability (that is, they are motivated but
not forced or otherwise compelled to do so).
The reporting entity will need to determine the characteristics of the market participants and
identify the assumptions that those market participants would consider when valuing the
contingent consideration. See Section 4.1 for further discussion of market participant
assumptions.
5 Similar guidance is provided in IFRS 13:38.
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Section 3: Characterizing Contingent Consideration
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Buyers and sellers commonly use contingent consideration when they cannot reach agreement on the
consideration to be paid for the acquired business, to mitigate the risk of the business not meeting
future performance expectations, to incent the sellers to help the business meet post-close targets
established by the buyer, and/or to allow the sellers to share in the upside potential. While contingent
consideration arrangements are often used to achieve similar purposes and exhibit certain common
characteristics, contingent consideration structures observed in practice come in many different forms
that are designed to address the unique risks associated with each specific transaction. An earnout6
may be broadly characterized by the choice of the underlying metric or event which triggers the
payment, the structure or payoff of the earnout, and the means by which the earnout is ultimately
settled.
Underlying Metric(s)
3.1
In this Valuation Advisory, the terms “underlying metric” and “metric”7 refer to a measurement unit
defined in the contingent consideration agreement, the value of which will (in some cases in
conjunction with the value of other metrics, occurrence or non-occurrence of specified events, or other
terms of the agreement) determine the amount of the contingent consideration to be paid. Typically,
an earnout metric will be a quantifiable measure the parties can use to track, monitor and assess the
success or failure of the acquired business, post-acquisition.
The metric(s) chosen by buyers and sellers when structuring an earnout is a key consideration when
valuing that earnout. Not only does an earnout derive its value from the underlying metric, but the
metric may provide the valuation specialist with useful insights as to the rationale for incorporating
the earnout in the transaction. For example, the metric may be indicative of the risks that the buyer
and seller designed the earnout to mitigate, or of the areas of the business that the seller has the most
ability to positively influence post-transaction. Ideally, the chosen metric(s) would represent the future
performance of the acquired business in a manner that is easily defined and objectively measurable.
Typical metrics include:
• Financial metrics: revenue (in some cases in conjunction with minimum gross margin
conditions), EBITDA, net income, and business metrics such as number of units sold, rental
occupancy rates, etc.8
• Nonfinancial milestone events: regulatory approvals, resolution of legal disputes, execution of
certain commercial contracts or retention of customers, closing of a future transaction,
achievement of technical milestones (such as completion of a product launch, a stage of
product development, certain software integration tasks, or a construction project), etc.
Occasionally, there are terms or metrics in a contingent consideration arrangement related to employee
retention. As noted in Section 2, for financial reporting purposes under ASC 805, payments that are
contingent on retention of employees are often classified as post-combination compensation expense
6 Clawbacks often have similar structures to earnouts but are generally paid by the seller to the buyer in cases of poor performance or
occurrence of downside events. To simplify the exposition in this Valuation Advisory, most of the examples and discussion will be
couched in terms of earnouts. Section 6 addresses discount rate and counterparty credit risk issues specific to clawbacks.
7 The terms “underlying metric” and “metric” will be used interchangeably in this Valuation Advisory.
8 Business metrics such as these, while not typically categorized as “financial metrics,” are often closely related to financial metrics.
The discussions in the remainder of this Valuation Advisory about financial metrics are also generally applicable to business metrics.
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rather than as contingent consideration. The specific accounting rules related to this determination are
beyond the scope of this Valuation Advisory.
The choice of the underlying metric will affect the riskiness of the contingent consideration payoff
cash flow and therefore the relevant discount rate. For example, as explained in Section 4.3, the risk
associated with certain nonfinancial milestone events (such as an earnout contingent on regulatory
approval of a pharmaceutical drug) might typically not be influenced by movements in the markets
and therefore such risks are diversifiable, leading to the use of a discount rate similar to the cost of
debt of the obligor over the appropriate time horizon.9 In contrast, the risk associated with a financial
metric will generally not be fully diversifiable, leading to the use of a discount rate that includes a risk
premium for that financial metric’s exposure to systematic risk.10
3.2
Contingent Consideration Payoff Structures
At one extreme, contingent consideration may be structured in a simple way as a fixed percentage of
an underlying metric such as earnings or revenue (i.e., a linear payoff structure). At the other extreme,
contingent consideration payoff structures may be complex, nonlinear functions of the underlying
metric, including minimum thresholds below which no payment is made, a maximum payment cap,
tiers with differing rates of payment per unit of improved performance, and/or carry-forward
provisions that link payment in one time period to performance in other time periods.
As discussed in Section 4.4, the contingent consideration structure can have a substantial impact on
the risk, degree of leverage, and discount rate to use in the valuation. Furthermore, similar to the
distinction between diversifiable and non-diversifiable risk (discussed in Section 4.3), the distinction
between linear and nonlinear payoff structures is a key consideration when selecting the contingent
consideration valuation methodology. In particular, the expected payoff of an earnout with a linear
structure (i.e., with no caps, thresholds, tiers, etc.) may be estimated based on the single payoff
associated with the expected (probability-weighted) outcome for the metric. In contrast, any payoff
structure that varies in any way from a purely linear structure—a nonlinear structure incorporating any
operative11 thresholds, caps, multiple tiers, carry-forwards, etc.—will require explicit consideration of
the probability distribution of possible outcomes for the metric and the associated payoffs.
3.2.1 Common Contingent Consideration Payoff Structures
The following examples present certain common contingent consideration payoff structures observed
in practice. A fixed payment (constant payoff) structure is also included—even though a non-
contingent payoff structure generally is not considered to be contingent consideration—to illustrate a
structural extreme. 12 Where the example contingent consideration payoff structure resembles the
payoff structure for an option, such as a put option or a call option, that resemblance is noted (in
parentheses). The impact of structure on risk alluded to in the examples is explained in Section 4.4.
Illustrative examples of fair value computations for each of these payoff structures (and additional
variations) are provided in Section 9.
9 See an example of the valuation of a technical milestone in Section 9.3.
10 The Required Metric Risk Premium is discussed in Section 5.2.2.
11 A cap might not be operative if, for example, the likelihood of the metric being above the cap is de minimis. Such a situation is more
likely to occur when the valuation of the contingent consideration is updated a year or two post-transaction (after some of the
uncertainty is resolved unfavorably) than for the initial valuation.
12 At initial recognition, a fixed payment would be considered deferred consideration. However, once the uncertainties are resolved, a
contingent consideration liability can resemble a fixed payment obligation, due at its contractual maturity.
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Structure
Payoff
Description and Risk Characteristics13
EXAMPLE STRUCTURES
Constant (debt-like)
Milestone payment
(digital / binary
option)
See Examples 9.3-9.4
Linear
See Examples 9.1-9.2
Percentage of total
above a threshold
(asset-or-nothing call
option)
See Example 9.6
Excess above a
threshold with a cap
(capped call option)
See Example 9.7
Excess above a
threshold (call option)
See Example 9.5
Clawback
(put option)
See Example 9.11
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Metric
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Metric
• A fixed (deferred) payment.
• The earnout cash flow is only subject to counterparty credit
risk.
• A fixed payment contingent upon achieving a future
milestone or performance threshold.
• Nonlinear payoff, where the risk of the earnout cash flow
depends on the risk of the underlying metric, the impact of
the nonlinear structure (which is non-zero if the metric’s
risk is non-diversifiable) and counterparty credit risk.
• Payment is equal to a fixed percentage of the outcome for
the underlying metric.
• Linear payoff, where the risk of the earnout cash flow is the
same as the risk of the underlying metric, plus counterparty
credit risk.
• Payment is equal to a percentage of the underlying metric,
but only if a performance threshold is reached.
• Nonlinear payoff, where the risk of the earnout cash flow
depends on the risk of the underlying metric, the impact of
the nonlinear structure, and counterparty credit risk.
• Payment is equal to a percentage of the excess of the
underlying metric above a performance threshold, with a
payment cap.
• Nonlinear payoff, where the risk of the earnout cash flow
depends on the risk of the underlying metric, the impact of
the nonlinear structure, and counterparty credit risk.
• Payment is equal to a percentage of the excess of the
underlying metric above a performance threshold.
• Nonlinear payoff, where the risk of the earnout cash flow
depends on the risk of the underlying metric, the impact of
the nonlinear structure, and counterparty credit risk.
• Payment is equal to a percentage of the shortfall of the
underlying metric below a performance threshold.
• Nonlinear payoff, where the risk of the clawback cash flow
depends on the risk of the underlying metric, the impact of
the nonlinear structure, and counterparty credit risk.
13 The discount rate for any of these structures should consider the time value of money, as well as the risks described in this table.
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3.2.2 Path Dependency
Contingent consideration arrangements may cover a short time period (e.g., three months) or a long
period (e.g., many years). In addition, the arrangement may specify a single measurement period or
multiple measurement periods. For some arrangements that include multiple measurement periods, the
payoff in each period may be independent of (and therefore can be valued separately from) the results
in other periods. Some arrangements, however, include carry-forward or catch-up features, overall
(multi-year) caps, or other terms that cause some of the payments to depend on the performance over
multiple periods. This latter type of contingent consideration is typically referred to as having path-
dependent features.
When a payment in one period is dependent on the outcomes in other periods, one typically cannot
model the payments independently. More complex techniques, the most common of which is a Monte
Carlo simulation, are generally required. See Section 5.4.4 for a description of a Monte Carlo
simulation.
Example: The acquirer is required to pay 70% of EBITDA above 1 million in year 1, and 70%
of EBITDA above 2 million in year 2, with an overall payment cap of 2 million. Due to the
overall payment cap, the earnout payment in year 2 depends on the earnout payment in year 1,
and is therefore path dependent.
Also, see the example in Section 9.10.
3.2.3 Multiple Underlying Metrics or Multiple Forms of Settlement
The contingent consideration payoff may depend on more than one underlying metric. In such cases,
each underlying metric would typically be modeled based on its forecast and risk characteristics,
taking into account the correlation between the metrics. In most cases the valuation of an earnout based
on multiple, correlated (or otherwise interdependent) underlying metrics will require a Monte Carlo
simulation.14
Example: The acquirer is required to pay 100 if first year post-close revenue exceeds 1,000
and first year post-close EBITDA exceeds 200. Expected first year post-close revenue and
EBITDA are 1,000 and 200, respectively.
In the example above, the situations in which revenue exceeds 1,000 are more likely to occur (but not
certain to occur) when EBITDA is above 200. That is, these two financial metrics (like most financial
metrics) are not independent; they are positively correlated. Because of this positive correlation, the
value of the earnout is higher than if the two metrics were independent. (To grasp this concept
intuitively, it might help to consider that whenever revenue exceeds 1,000, EBITDA is more likely to
exceed 200 if the two metrics are positively correlated than if they are independent.) A Monte Carlo
simulation is one technique that can incorporate the impact of the correlation between revenue and
EBITDA on the value of the earnout. In contrast, if (instead of EBITDA) the criterion related to a
nonfinancial milestone whose achievement had no impact on or relationship with first year revenue
(for example, on-time completion of the first year of a multi-year new product development effort that
will produce no revenues until the new product is launched), then in this example a Monte Carlo
simulation would not be required.
14 In rare situations, it may be possible to simplify the analysis by modeling one risky metric in terms of another, under certain strong
assumptions about the relationship between the risky metrics (such as where the relationship between the metrics can be reasonably
modeled as perfectly correlated).
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Similarly, the contingent consideration payoff may require settlement in more than one form. In such
cases, each form of settlement needs to be modeled based on its risk characteristics, taking into account
the correlation between the metric(s) and the form of settlement.
See Sections 5.3.6 and 5.4.4 for a description of Monte Carlo simulation in the context of SBM and
OPM, respectively.
3.2.4 Buyer or Seller Choices
In rare cases, the earnout is structured with the ability of the buyer or seller to make a decision during
or at the conclusion of the earnout period, which will impact the form, amount, or settlement type for
the earnout payment. In these cases, and consistent with fair value concepts, the valuation specialist
needs to consider the optimal decision that would either maximize (in the case of a seller decision) or
minimize (in the case of a buyer decision) the value of the earnout payment.
Example: An earnout equal to 10% of future EBITDA over five years, where each year the
seller can choose between continuing to receive the contingent payments or receiving a pre-
specified cash settlement amount.
The above example illustrates that the introduction of a choice can turn a simple, linear contingent
consideration payment that can be valued based on the expected EBITDA into a complex, path-
dependent, nonlinear arrangement for which the valuation requires a full understanding of the
distribution of future outcomes and the use of methods such as a binomial (lattice) model (discussed
in Section 5.4.5) or a Monte Carlo simulation in conjunction with an algorithm that incorporates
optimal decision making.15
3.2.5 Currency
The currency in which an earnout is structured and/or settled can significantly impact its fair value. In
most cases, all the features of the earnout arrangement (including settlement, performance thresholds,
payment caps, etc.) are denominated in a single, common currency. Such a single, common currency
is usually the currency in which the valuation analysis is performed, to avoid the need to model future
foreign exchange rates.
Example: An earnout payment of 1,000 Brazilian Real if EBITDA earned in the first year
exceeds 2,000 Brazilian Real.
Since all the earnout features are contractually denominated in Brazilian Real, the valuation analysis,
including all assumptions, is usually more easily performed in Brazilian Real. Once the fair value of
the earnout is estimated in a specific currency, then the fair value can be converted to other currencies
as needed, for example by using the appropriate spot foreign exchange rate at the measurement date.
For earnout arrangements with terms that span multiple currencies (where the multiple currency
exposure is substantial), the valuation can be significantly more complicated, as discussed further in
Section 5.2.7.
3.3
Settlement Types for Contingent Consideration
While most earnouts are settled in cash, there are cases where settlement involves the transfer of other
assets, equity, and/or liabilities. For example, an earnout may be settled in the acquirer’s shares, which
15 In some situations, the algorithm can be a relatively simple decision rule assessed by management. For more complex situations such
as the path-dependent early exercise option in the example above, there are many algorithms and techniques that have been developed.
See for example, Longstaff and Schwartz (2001), “Valuing American options by simulation: A simple least-squares approach.”
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may be specified as a fixed number of shares or as a fixed monetary value of shares. The currency in
which the earnout is settled will also have an impact on the valuation (see Section 3.2.5).
The way an earnout is settled may or may not have an impact on its fair value.
Example (settlement in fixed monetary value of shares): An earnout payment equal to $500
worth of the acquirer’s common shares if EBITDA earned in the first year exceeds $5,000.
In the above example, the earnout payment is specified in monetary terms, but settled through the
transfer of other assets (the acquirer’s common stock in this example). Such an earnout is economically
equivalent to an earnout settled in cash.
Example (settlement in fixed number of shares): An earnout payment equal to 500 common
shares of the acquirer if EBITDA earned in the first year exceeds $5,000.
However, specifying an earnout as a fixed number of the acquirer’s shares (as in the example above)
will impact the fair value of the earnout, and the valuation of such an earnout generally requires
consideration of the fair value of the shares being transferred, the impact on the counterparty credit
risk (if any, see discussion and examples in Section 5.2.6) and the correlation between the value of the
shares and the underlying metric. Also, a contingent consideration obligation that requires settlement
in the acquirer’s shares may be classified as either a liability or as equity for financial reporting
purposes, depending on facts and circumstances.
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Section 4: Key Valuation Concepts Related to Earnouts
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There are several concepts that are key to understanding why certain methodologies are, or are not,
appropriate for valuing various types of contingent consideration:
• Market participants and their assumptions: since fair value requires one to assume a
transaction involving the contingent consideration on a standalone basis, it is important to
carefully consider the perspectives of the relevant market participants on issues such as the
inclusion of synergies.
• Probabilistic forecasts: contingent consideration valuation often requires an understanding of
the probability distribution of potential outcomes for the underlying metric, not just the
expected (probability-weighted, mean) outcome.
• Diversifiability of risk: contingent consideration payoffs may depend on metrics that are
largely uncorrelated with the market, which can simplify the valuation analysis. However, if
the risk associated with the metric is non-diversifiable, valuation complexities can arise and
affect the choice of valuation methodology.
• Payoff structure: whether the payoff is a nonlinear function of the underlying metric has
implications for the risk of, and therefore the discount rate used for, the contingent
consideration cash flow.
• Leverage: contingent consideration payoff structures often entail a leveraged exposure to the
underlying metric(s), which affects the riskiness of the contingent consideration cash flow.
• Risk-neutral valuation: this concept of adjusting for risk is a fundamental underpinning of
the option pricing method.
These key valuation concepts will be referenced throughout this Valuation Advisory.
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4.1 Market Participant Assumptions
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As explained in Section 2.2, the objective of a fair value measurement is to estimate the price at which
an orderly transaction would take place between market participants under the market conditions that
exist at the measurement date. In the context of contingent consideration, therefore, developing a fair
value estimate requires identification of the assumptions of market participants for the contingent
consideration as a freestanding instrument.
It is rare for the parties to contingent consideration arrangements to subsequently transact in or sell
their interest in the arrangement as a freestanding instrument; there is not an established market for
trading of most contingent consideration arrangements. 16 Rather, the parties typically retain their
respective interests until the contingencies have been resolved and any payments made. As a result,
one does not typically observe how market participants value and price contingent consideration
arrangements as separate freestanding instruments. Therefore, careful consideration of the assumed
orderly transaction and the perspectives of the relevant market participants may require significant
judgment.
The market participants for the contingent consideration may be different from the market participants
for other items requiring fair value determinations in a business combination. For example, the market
participant for an acquired intangible asset might be a company that operates in the same industry with
similar products. For a contingent consideration arrangement, the market participant purchasing the
16 A rare exception (contingent value rights) is discussed in Section 5.1.
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rights to receive the future contingent payments or assuming the contingent payment obligations could
be a private equity firm, hedge fund or some other investor wanting to gain exposure to the acquired
business by purchasing the rights to receive future payments, or willing to assume the risk of
potentially paying the future contingent payments in exchange for a lump sum cash payment on the
measurement date.
The perspective of market participants transacting in the contingent consideration arrangement may
also differ from that of market participants transacting in other items requiring fair value measurement
in a business combination. For example, a market participant for an intangible asset would not consider
post-combination synergies that are specific to the acquirer when estimating the projected cash flows
related to that intangible asset. Similarly, the financial projections developed for valuing an acquired
business typically only include market participant synergies, not buyer-specific synergies. On the other
hand, a market participant transacting in an earnout arrangement on a standalone basis would consider
all relevant post-combination synergies, including those specific to the acquirer. This is because any
payments ultimately due will reflect the contractual terms of the earnout arrangement and buyer-linked
characteristics are implicit elements of that contract. A market participant for the standalone earnout
would therefore consider the impact of buyer-linked characteristics when estimating the projected
earnout cash flow and pricing the earnout arrangement.
To summarize, all synergies relevant to the calculation of the payoff, i.e. all synergies not excluded
contractually from the definition of the metric underlying the contingent consideration, including all
relevant buyer-specific synergies, should be included in the financial projections for the contingent
consideration valuation.
Similarly, market participants valuing a contingent consideration arrangement would consider risks
specific to the post-acquisition business in developing assumptions for other inputs. For example, if
an earnout has been put in place to share the risk of a large uncertainty around the degree of success
for a new product launch, then a market participant would estimate a volatility specific to these
circumstances—which might be considerably higher than the volatility observed for public company
comparables.
4.2
Probabilistic Forecasts and Expected Values
The valuation of earnouts often requires the use of probabilistic models. That is, one typically needs
to contemplate future scenarios and their associated probabilities (i.e., a probability distribution) to
correctly estimate the expected future earnout payment. For clarity, in this Valuation Advisory, all
uses of the term “expected” as an adjective, including expected case, expected payment, expected cash
flow, expected value, etc. refer to the mean—the mean case (the mean, probability-weighted result
across the possible outcomes, not the most likely case), the mean payment, the mean cash flow, and
the mean value, respectively. In addition, all uses of the term “probability” refer to the real-world
probability of an outcome, unless the context is explicitly described as involving a “risk-neutral”
probability in a risk-neutral framework (see Section 4.6).
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A key concept in valuing earnouts is to recognize that, except for linear payoff structures,17
the expected cash flow for the contingent consideration
is usually NOT equal to
the payoff associated with the expected value of the metric.
Example: An earnout with a payoff equal to the excess of future EBITDA above 100, where
forecast EBITDA is 100, and the probability of various outcomes is as shown in the first three
columns of Table 1 below.
Scenario
Probability
EBITDA
TABLE 1
1
2
3
4
5
6
7
2.5%
15%
20%
25%
20%
15%
2.5%
Expected Value:
180
130
120
100
80
70
20
100
Earnout Payoff
(Max (EBITDA-100,0))
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30
20
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In the above example, the future earnout payoff associated with the expected EBITDA forecast of 100
is zero, but zero is not the expected future cash flow of the earnout. To calculate the expected future
cash flow of the earnout, one needs to consider the probability of being above or below the forecast
(i.e., one needs to consider the probability distribution of future EBITDA). Consideration of the full
probability distribution for the EBITDA metric leads to a variety of scenarios for the earnout payoff
such as those shown in the last column of Table 1.
Based on the probability distribution in Table 1, the correct expected earnout cash flow in this example
is equal to 10.5,18 not zero.
As the example in Table 1 illustrates, an understanding of the full distribution of outcomes is often
required for the valuation of an earnout. As for any valuation, it can be important to confirm that the
financial projections provided by management represent the expected (probability-weighted, mean)
case. However, when valuing an earnout, it can additionally be important to investigate whether the
valuation specialist’s assumption regarding the probability distribution around that mean (e.g., a
distribution with a volatility in growth rate for the metric based on an analysis of comparable
companies in the industry) is appropriate. Such an investigation might identify an event, for example
the timing of a new product launch or the effectiveness of a potential new partnership, that
substantially affects the distribution (or even the mean) of outcomes over the timeframe for the
earnout. While these kinds of diversifiable, near-term events might not affect the long-term value of
the business, they can have a sizeable impact on the value of the earnout. Similarly, an investigation
17 For example, when the earnout is a flat percentage of the underlying metric (i.e., a linear payoff structure with no thresholds, caps,
tiers, carryforwards, minimum levels of profitability, or other terms or conditions), the expected earnout cash flow is equal to the
payoff at the expected metric outcome. See the examples of a linear structure in Sections 9.1 and 9.2.
18 Specifically, the computation to arrive at the expected payoff is (80×2.5%) + (30×15%) + (20×20%) + (0×62.5%) = 10.5.
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might identify that there is a wider range of uncertainty around the mean financial projections for a
young, high-growth business than there is for the public company comparables in the industry. Any
such issues identified should be captured in the valuation specialist’s modeling of the distribution of
outcomes for the underlying metric.
See Sections 5.2.1 and 5.2.4 for a more in-depth discussion of methods for estimating the mean for
the underlying metric and the probability distribution around that mean.
Another important factor to consider is consistency between the assumed probability distribution for
the underlying metric in the earnout analysis and the forecasts for that metric implied by the expected
case cash flows used to value the business.19 See Section 7.1 for a discussion of this issue and an
example.
4.3
Diversifiable and Non-Diversifiable Risk
A widely accepted valuation principle assumes that rational investors and market participants reduce
risk through diversification. As a result, it is assumed that market participants will only require a return
premium for those risks that cannot be diversified away. Therefore, for valuation purposes, risks are
often categorized into two broad groups.
• Non-diversifiable risk: risks that cannot be fully removed through diversification (such as
systematic risks, i.e., risks that are correlated with the market)
• Diversifiable risk: risks that can be diversified away.20 For example, an event whose outcome
is not influenced by movements in the markets is a diversifiable risk; such risks are often
illustrated by comparison to a coin flip.
The categorization of the risk associated with the underlying metric as diversifiable or non-
diversifiable is a key consideration when estimating the value of contingent consideration. In
particular, whether the risk associated with the underlying metric is diversifiable will affect the
estimation and the magnitude of the required rate of return (or discount rate) associated with the
contingent consideration.
To illustrate this concept, suppose that the risk associated with the underlying metric for an earnout is
largely diversifiable. In the context of contingent consideration, events with predominantly
diversifiable risks include, for example, a payment contingent upon receiving regulatory approval,
upon favorable resolution of a legal dispute, upon timely completion of a construction project, or upon
achievement of technical milestones such as successfully completing a software integration task or
development of a new product.21
19 Note however, that the mean forecast for the metric associated with the expected case cash flows used to value the business might
differ from the mean forecast for the metric used to value the earnout, due to the impact of buyer-specific synergies. See Section
4.1.
20 For clarity, note that a diversifiable risk need not be one where you can make another investment with a favorable result if the
uncertainty is resolved in the negative direction. Diversifiability does not imply that you can cancel out the uncertainty and remove
the possibility of a negative outcome for a single uncertain event. Rather, a diversifiable risk is a peril that is peculiar to an
individual company. An investor’s portfolio can include numerous (unrelated, i.e. diverse) investments that entail such risks. The
more such (unrelated) investments there are in the portfolio, the more likely it is that the expected outcome will be achieved across
the portfolio, due to the law of large numbers. The same level of assurance of achieving the expected case cannot be achieved with
a portfolio of non-diversifiable risks, since they are all, to some degree, interdependent, due to their correlation with movements in
the market. See, e.g., Principles of Corporate Finance by Brealey, Myers, Allen (2013), p. 174.
21 While there may be a small degree of systematic risk associated with the achievement of technical or regulatory milestones, in most
cases, the non-diversifiable risk is de minimis as compared to the diversifiable risk. Assuming the risk associated with such events
to be diversifiable is therefore generally considered reasonable.
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Example: The acquiree has a pharmaceutical drug under development that has passed clinical
trials. An earnout is structured that pays one million if that drug receives regulatory approval.
The discount rate associated with the expected (probability-weighted, mean) cash flow contingent on
a metric with only diversifiable risks is the risk-free rate, plus any adjustment for counterparty credit
risk.22 In the above example, the risk-free rate plus any adjustment for counterparty credit risk would
be the discount rate to apply to (one million × the probability the drug receives regulatory approval).
No additional premium for systematic risk needs to be incorporated in that discount rate.
This is not to say that even a fully diversifiable metric is not subject to uncertainty. Indeed, the
likelihood of occurrence of an event on which an earnout is based could be high or low, but it is
typically uncertain. That likelihood of occurrence should be incorporated in the calculation of the
expected payoff (in the above example by multiplying the payoff of one million by the probability of
receiving regulatory approval).
Conversely, if the risk associated with the underlying metric for an earnout is non-diversifiable, market
participants require a risk premium23 above the risk-free rate as compensation to take on such non-
diversifiable risk. In the context of contingent consideration, metrics with non-diversifiable risk
include financial metrics such as revenue, EBITDA, number of units sold, rental occupancy rates, etc.
If the earnout metric exhibits systematic risk, then the discount rate applied to the expected payoff will
be affected by the structure of the earnout, as described in more detail in Section 4.4.
4.3.1 Capital Asset Pricing Model Framework for Quantifying Non-Diversifiable Risk
The Capital Asset Pricing Model (CAPM) is a framework that is widely used to estimate the required
rate of return or discount rate associated with an investment. While the recommendations and best
practices discussed in this Valuation Advisory do not require use of CAPM, many principles
surrounding the estimation of a risk premium for non-diversifiable risk will be illustrated in a CAPM
framework. The same principles would apply to other models for estimating systematic risk, such as,
for example, models that provide various adjustments to CAPM (some of which are discussed later in
this section) or the Fama-French Five-Factor Model (Fama and French 2015).
Simply stated, CAPM describes investors' required rate of return for a security as being comprised of
two components: compensation for the time value of money and for taking on non-diversifiable risk.
As shown in the equation below, in a CAPM framework, the time value of money is represented by
the risk-free rate, which compensates investors for the risk-free return they could have earned over the
holding period of the investment. The systematic risk component is represented by the beta of the
investment, which quantifies the degree of non-diversifiable risk based on the volatility of the
investment relative to the market volatility and the correlation of its performance with the market,
multiplied by the Market Risk Premium.
22 See Sections 5.2.6 and 6.3 for discussions of the incorporation of the obligor’s credit risk into the valuation of contingent
consideration.
23 The Required Metric Risk Premium is discussed in Section 5.2.2.
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Where:
𝑅𝑅𝐴𝐴 = 𝑅𝑅𝑅𝑅𝑅𝑅 + 𝛽𝛽𝐴𝐴(𝑅𝑅𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 − 𝑅𝑅𝑅𝑅𝑅𝑅) = 𝑅𝑅𝑅𝑅𝑅𝑅 + 𝛽𝛽𝐴𝐴𝑀𝑀𝑅𝑅𝑀𝑀
= Required rate of return for security A
RA
RFR = Risk-free rate of return
A
= Beta of security A
RMarket = Expected return on the market portfolio
𝛽𝛽
MRP = RMarket ‒ RFR = Market Risk Premium
The CAPM definition of risk is consistent with the notion that rational investors will try to diversify
away risk, which leaves only risk that is non-diversifiable as impacting the required risk premium. For
a given investment, non-diversifiable risk depends on the volatility of returns for the investment
relative to the market, as well as the extent to which the investment’s returns are correlated with the
market returns (as captured by beta), and can be quantified by multiplying beta by the Market Risk
Premium.
Valuation specialists often also factor in adjustments to the CAPM results, as illustrated by the
equation below, to capture additional risk beyond what is captured by the traditionally measured beta
associated with the textbook CAPM. Some of these additional risk premiums include adjustments
based on company size (size premiums24), country-related risk (country-specific risk premiums), and
company-specific risk (alpha). For simplicity of exposition, in this Valuation Advisory we will refer
to the CAPM results with adjustments to capture additional risk premiums as the “Adjusted CAPM”
framework.
Where:
𝑅𝑅𝐴𝐴 = 𝑅𝑅𝑅𝑅𝑅𝑅 + 𝛽𝛽𝐴𝐴(𝑅𝑅𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 − 𝑅𝑅𝑅𝑅𝑅𝑅) + 𝑆𝑆𝑀𝑀 + 𝐶𝐶𝑅𝑅𝑀𝑀+∝ = 𝑅𝑅𝑅𝑅𝑅𝑅 + 𝛽𝛽𝐴𝐴𝑀𝑀𝑅𝑅𝑀𝑀 + 𝑆𝑆𝑀𝑀 + 𝐶𝐶𝑅𝑅𝑀𝑀+∝
RA
RFR = Risk-free rate of return
= Required rate of return for security A
A
= Beta of security A
RMarket = Expected return on the market portfolio
𝛽𝛽
MRP = RMarket ‒ RFR = Market Risk Premium
SP
CRP = Country-specific risk premium
= Size premium
= Company-specific risk premium, where
can be positive, zero or negative
∝
The following example illustrates at a high level how the estimated CAPM risk premium might be
adjusted, and that such adjustments typically result in a risk premium that is more consistent with the
risk premium implied by the transaction internal rate of return (IRR).25
∝
24 A size premium typically reflects the higher return required by market participants for investing in companies that are smaller in size.
For a textbook discussion, see, e.g., Cost of Capital by Pratt and Grabowski (2014).
25 As noted in the Appraisal Practices Board’s Valuation Advisory #2 – The Valuation of Customer-Related Assets, Section 5.2.25,
“The WACC and the IRR should be compared and reviewed for reasonableness. An IRR that is significantly different from the
WACC may warrant a reassessment of both the [Prospective Financial Information (PFI)] and the WACC calculation to determine
if market participant assumptions are being consistently applied or if adjustments need to be made in either the PFI or WACC.
While the purchase consideration is most often the best indication of fair value, the valuation specialist needs to be alert for
circumstances when this is not the case and there is evidence of, for example, buyer-specific synergies, overpayment, or a bargain
purchase.”
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Example: Suppose the IRR for an acquisition of a small private company is 20% per annum
and a 10% required rate of return (2% risk-free rate plus 8% risk premium) is estimated in a
CAPM framework (assuming no debt) using comparable, publicly traded companies.
However, the valuation practitioner has identified that it is appropriate to add a size premium
of 10% due to non-diversifiable risk associated with the company’s size. As a result, the
transaction IRR and the estimated WACC for the company are consistent, as shown in the
figure below.
20%
10%
8%
2%
Additional premiums such as size, company-specific, and/or
country-specific premiums
Estimated CAPM risk premium for comparable public
companies (i.e., Beta × MRP)
Risk-free rate
IRR of
Transaction
WACC
Buildup
Note, however, that the WACC may not always reconcile to the IRR as it does in the above illustration.
If the IRR is significantly higher than the WACC, the valuation specialist will typically consider
whether the projected cash flows truly represent expected case, market participant cash flows, or if
there may be an optimistic bias that should be removed and/or unmodeled risks that should be
addressed. Alternatively, if the projected cash flows are representative of probability-weighted,
expected case cash flows using market participant assumptions, and the IRR is still significantly higher
than the WACC, the valuation specialist will typically consider the possibility that the transaction
price represents a bargain purchase.
Similarly, if the IRR is significantly lower than the WACC, the valuation specialist will typically
consider whether the projected cash flows have a conservative bias or exclude market participant
synergies that should be included. If the projected cash flows are representative of probability-
weighted, expected case cash flows using market participant assumptions, and the IRR is still
significantly lower than the WACC, the valuation specialist will typically consider the possibility of
an overpayment situation.
The concept of additional risk premiums also applies to the valuation of contingent consideration.
Suppose there is an earnout structured as part of this transaction that requires the acquirer to pay 5%
of future revenue to the seller in perpetuity.26 The discount rate applied to the expected cash flow of
this earnout should take into account the portion of the additional size, country-specific and/or
company-specific risks identified by the valuation specialist that are applicable to the expected cash
flow associated with the earnout.27
26 Note that this is a linear payoff structure. Additional complexities can arise in the estimation of the appropriate discount rate for a
nonlinear earnout payoff structure based on a metric with non-diversifiable risk, as described in Section 4.4. Whether the structure is
linear or nonlinear, however, the additional risks related to the business identified by the valuation specialist should also be considered
for the earnout valuation.
27 If an alternative framework to the Adjusted CAPM were used, the same principle would apply: the discount rate applied to the
expected earnout cash flow should include the earnout-appropriate portion of the risk premiums employed in that framework.
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4.4
The Risk Associated with the Contingent Consideration Payoff Structure
The payoff structure can affect the risk associated with an earnout, if the risk of the earnout metric is
non-diversifiable.
For a metric with only diversifiable risk, the appropriate discount rate is the risk-free rate, plus any
adjustment for counterparty credit risk, applied to the expected earnout cash flow over the relevant
time horizon. When there is no systematic risk associated with the metric, the payoff structure cannot
affect the amount of systematic risk and therefore the payoff structure does not affect the magnitude
of the required rate of return.
For a metric (such as a financial metric) with non-diversifiable risk, the relative risk of the earnout as
compared to the risk of the underlying financial metric will depend on the earnout payoff structure.
A simple earnout that pays a fixed percentage of a financial metric such as revenue (a linear payoff
structure) has the same risk as that revenue (over the relevant timeframe). However, as illustrated in
Section 3.2, earnouts typically exhibit more complex payoff structures, such that the amount of
payment depends on whether the performance with respect to a financial metric satisfies certain
contingencies (e.g., reaches a threshold, a tier, or a cap). When this is the case, i.e., when the payoff
structure is nonlinear, the risk of the earnout cash flow can diverge significantly from the risk of the
underlying metric. For a metric with non-diversifiable risk and a nonlinear payoff structure, the risk
of the earnout will depend not only on the risk associated with the metric, but also on the probability
of achieving each threshold, tier, cap or other structural element.
Consider the two financial-metric-based earnouts illustrated in Figure 1 below. For the milestone
(binary) payoff structure 1(a) illustrated on the far left, upon achieving a specified level of earnings
(above a threshold), a fixed amount is paid. For the payoff structure in illustration 1(c), upon achieving
a specified level of earnings (above a threshold), the payoff is an amount proportional to the earnings.
This structure is similar to an asset-or-nothing payoff structure for an option. If the probability of
achieving the earnings threshold is 100% (as depicted by the pattern of dotted and solid lines in Figure
1, the payoff will occur with certainty at some point along the solid line), then the milestone payment
structure in 1(a) is equivalent to a deferred payment (referred to in illustration 1(b) below as “debt-
like”), and the risk of the asset-or-nothing payoff structure in 1(c) is equal to the risk of the underlying
earnings (i.e., equivalent to a linear payoff structure as shown in illustration 1(d)).
Milestone Earnings
Example:
Milestone (Binary)
1(a)
f
f
o
y
a
P
FIGURE 1
Percent of Total Earnings Above a Threshold (Asset-or-Nothing)
Example:
Constant (Debt-Like)
1(b)
Asset-or-Nothing
1(c)
Linear
1(d)
f
f
o
y
a
P
f
f
o
y
a
P
f
f
o
y
a
P
Earnings
0% probability
Earnings
>0% probability
Earnings
0% probability
Earnings
>0% probability
713
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715
However, if the probability of achieving the earnings threshold is less than 100% (i.e., unlike as shown
in Figure 1, if there is some chance that the earnings outcome will be less than the threshold and the
earnout payoff will be zero), the risk of the milestone earnout cash flow will be greater than that of a
VFR Valuation Advisory #4 - Valuation of Contingent Consideration
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deferred payment and the risk of the asset-or-nothing earnout will be greater than the risk of the
earnings metric. Similarly, the risk of the cash flow of an earnout structured as an asset-or-nothing
option is always at least as great as the risk of the underlying financial metric. How much greater will
depend on the probability of achieving the threshold.
This same logic can be applied to another common earnout payoff structure, which has both a threshold
and a cap.
•
If the probability of earnings being above the level at which the cap is in force is 100% as
shown by the solid line in structure 2(a) on the left of Figure 2 below, then the earnout cash
flow is equivalent to a deferred payment (debt-like, see illustration 2(b)).
FIGURE 2
Asset-or-Nothing with Cap
2(a)
Constant (Debt-Like)
2(b)
f
f
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a
P
f
f
o
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a
P
Earnings
0% probability
Earnings
>0% probability
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•
If the probability of earnings being above the threshold is 100% (and the probability of hitting
the cap is less than 100%, as shown by the solid lines in structure 3(a) on the left of Figure 3
below), then the risk of the earnout cash flow is between the risk of a deferred payment, see
3(b), and the risk of the earnings, see 3(c), as illustrated on the right side of Figure 3 below.
FIGURE 3
Constant (Debt-Like)
3(b)
f
f
o
y
a
P
Earnings
Linear (same risk as underlying metric)
3(c)
f
f
o
y
a
P
Earnings
Asset-or-Nothing with Cap
3(a)
f
f
o
y
a
P
Earnings
0% probability
>0% probability
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•
If the probability of earnings being between the threshold and the cap is 100% (neither the
threshold nor the cap is “active,” as shown by the dotted lines in structure 4(a) on the left of
Figure 4 below), then the structure is effectively linear and the risk of the earnout payoff is
equal to the risk of the earnings metric, see 4(b), as illustrated on the right side of Figure 4
below.
VFR Valuation Advisory #4 - Valuation of Contingent Consideration
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FIGURE 4
Asset-or-Nothing with Cap
Linear (same risk as underlying metric)
4(a)
4(b)
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a
P
f
f
o
y
a
P
Earnings
Earnings
0% probability
>0% probability
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• Finally, if the probability of earnings being below the level at which the cap is in force is 100%
(and the probability of hitting the threshold is less than 100%, as illustrated by the solid lines
in structure 5(a) on the left side of Figure 5 below), then the risk of the earnout cash flow is
greater than the risk of the earnings (see 5(b) on the right side of Figure 5).
FIGURE 5
Asset-or-Nothing with Cap
Linear (same risk as underlying metric)
5(a)
5(b)
f
f
o
y
a
P
>
f
f
o
y
a
P
Earnings
Earnings
0% probability
>0% probability
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Thus, when the earnout metric has non-diversifiable risk, the risk of the contingent consideration
payoff is inherently tied to the likelihood of achieving a threshold, tier or cap. 28 The lower the
probability of achieving the threshold for example, the greater the leveraged position of the earnout
relative to the underlying financial metric and the higher the risk of the earnout payoff (see Section
4.5 on leverage).
Based on these types of considerations, it is possible to rank order the riskiness of a financial metric-
based earnout’s cash flow as shown in Figure 6 below. In this figure, the least risky payoff structure
is on the far left, and the most risky payoff structure is on the far right. The gray arrows indicate that
the ordering of risk of certain structures depends on the specific circumstances (in particular, it depends
on the likelihood of achieving the threshold and/or the cap). For example, a milestone payoff structure
is always less risky than an asset-or-nothing payoff structure, assuming the same likelihood of
achieving the threshold in each case. But whether a milestone payoff structure is more or less risky
than a linear payoff structure depends on the likelihood of achieving the milestone.
28 The likelihood of achieving a threshold for a contingent consideration metric is similar to the concept of “moneyness” in the context
of an option. “Moneyness” refers to the relative position of the current price of an asset to the strike price of an option written on
that underlying asset. The lower the probability of achieving the threshold, the less likely it is that any earnout amount will be paid,
and the more likely it is that the earnout is “out of the money.”
VFR Valuation Advisory #4 - Valuation of Contingent Consideration
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FIGURE 6
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Constant
(debt-like)
Milestone
payment
(binary option)
Linear
Percent of total
above a threshold
(Asset-or-nothing
call option)
Threshold and cap
(capped call
option)
Excess above a
threshold (call
option)
For an earnout with a nonlinear payoff structure based on a metric with non-diversifiable risk, the time
remaining until the uncertainty is resolved can also affect the systematic risk of the earnout cash flow
through the impact of time on the variability of the outcome. For example, assume a milestone
structure with a revenue metric for the first year post-close and for which the probability of achieving
the revenue target is 50%. The risk associated with the earnout cash flow will be very different if the
time remaining to achieve the revenue target is one year or one week.
4.5
The Impact of Payoff Structure on Risk: the Analogy to Leverage
The analogy to leverage provides important insights into the risk associated with nonlinear contingent
consideration payoff structures based on financial metrics. Leverage is most commonly thought of as
an equity holder’s leveraged exposure to the underlying business given the presence of debt. More
generally, leverage can be characterized as a payoff resulting from something that is risky less
something that is risk free (or relatively close to risk free29).
Common examples of leverage include:
• Equity as a leveraged exposure to the underlying business:
Equity = Enterprise Value – Debt
• A forward contract’s leveraged exposure to the underlying stock:
Forward Contract = Stock Price – Forward Price
• A call option’s leveraged exposure to the underlying stock:
Stock Option = Max (Stock Price – Strike Price, 0)
• Operational leverage as a result of fixed costs:
EBITDA = (Revenue Net of Variable Costs) – Fixed Costs
• Financial leverage as a result of fixed interest expense:
Net Income = EBITDA – Interest Expense
To illustrate the impact of leverage on the value of an earnout, consider an earnout that has a payoff
equal to 100% of the excess of future EBITDA earned over the next year above 100:
29 Assumptions about whether debt risk is diversifiable (whether debt repayment is correlated with the market) characterizes some of
the differences among methods for estimating the Required Metric Risk Premium associated with certain earnout metrics. See Section
10.3.1 in the Technical Notes portion of the Appendix.
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• Payoff of earnout = Max(Future EBITDA in 1 year – 100, 0)
• Assume:
o Forecast (expected value) for EBITDA earned over 1 year = 120
o Discount rate applicable to forecast 1-year EBITDA = 10%
o Achievement of future EBITDA of at least 100 is nearly certain30
o 1-year risk-free rate = 1%
o Enough money has been put into escrow that the counterparty credit risk is de minimis.
Under the stylized assumptions above, of the total expected 120 in EBITDA, the first 100 is certain
and therefore has no risk. All the risk is in the performance above that threshold of 100. More
generally, the lower, easier to achieve levels of a metric are far less risky than the overall metric risk.
Higher, more difficult to achieve levels of a metric are far riskier than the overall metric risk. Using
the above example, we can see the impact this concept of leverage has on the value of the earnout.
The relevant calculations for the example (assuming a mid-period convention31) are as follows:
• Value of all future EBITDA =
• Value of first (risk-free) 100 of EBITDA =
• Value of earnout is the difference =
120/1.100.5 = 114.4
100/1.010.5 = 99.5
14.9
Since the expected payoff of the earnout is 120 – 100 = 20, the implied discount rate for the earnout
is (20 ÷ 14.9) − 1 ≈ 34%. That is, the earnout is much riskier than the underlying EBITDA metric. Just
like equity entails greater risk the greater the company’s level of debt (due to leverage), so too does
the imposition of a threshold on a non-diversifiable metric like revenue or EBITDA increase the
riskiness of the earnout cash flow.
The impact of leverage on the riskiness of an instrument can be significant, and earnouts structured as
the excess of a financial metric above a threshold can be subject to significant leverage (as illustrated
above). For a similar reason, structuring an earnout with a cap (removing the highest risk outcomes
for the financial metric) makes that earnout less risky than it would be without the cap.
To further illustrate how a nonlinear payoff structure can affect the discount rate, Table 2 below depicts
the implied discount rates32 for certain traded S&P 500 call options, as a function of the term of the
option and its moneyness. In this example, moneyness refers to the relative position of the current
price of the S&P 500 to the strike price of an option written on the S&P 500. The implied volatility is
the S&P 500 volatility derived from the traded price of the call option with the corresponding term
and moneyness. Assuming a 7% (annual effective) cost of equity for the S&P 500 index, the discount
rates implied by the traded prices for these call options are high, due to the impact of leverage (no
payoff is achieved unless the threshold, i.e. the strike price, is reached). Such high discount rates are
not easy to estimate (without using an option pricing framework) and may not be intuitive for many
valuation specialists and their clients.
30 This assumption is made so that the payoff can be assumed to be approximately linear, in order to illustrate the impact of leverage.
The resulting implied discount rate is the same if we relax this assumption (i.e., assume that EBITDA can fall below 100), but
assume that the payoff of the earnout is strictly linear i.e., equal to Future EBITDA in 1 year – 100 (with no payment floor). Since
forecast EBITDA is risky and the threshold of 100 is contractual, the applicable discount rates are 10% and 1%, respectively.
31 See Section 5.2.5 for a discussion about the appropriate in-period discounting convention for the valuation of contingent consideration.
32 The Working Group is not suggesting that the valuation specialist needs to calculate an implied discount rate. Table 2 and the example
provided above are intended only to illustrate the impact of leverage on the risk of a nonlinear payoff structure.
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TABLE 2: Implied Discount Rates for S&P 500 Call Options33
Term
(yrs)
2.22
2.22
2.22
2.22
2.22
2.22
2.22
1.22
1.22
1.22
1.22
1.22
1.22
1.22
Moneyness
106.77%
101.91%
98.91%
93.42%
84.08%
76.43%
74.74%
103.48%
101.91%
98.91%
96.09%
90.89%
86.23%
80.07%
Implied Volatility
19.24%
18.42%
17.87%
16.79%
15.40%
14.25%
14.18%
17.66%
17.28%
16.52%
15.83%
14.58%
13.58%
12.99%
Call Option: Implied
Discount Rate
31.03%
34.81%
37.76%
44.82%
61.81%
85.87%
91.13%
49.34%
52.56%
60.00%
68.80%
92.21%
125.00%
180.11%
811
812
813
814
815
816
817
818
819
820
821
822
823
824
825
826
827
828
829
830
831
832
833
834
835
In the context of an earnout, the relative position of the expected outcome for an earnout metric to the
threshold for a payoff is a similar concept to moneyness in an option context.
Contingent consideration arrangements tend to be more complex than the stylized leverage example
above, often including the combination of a threshold and a cap, multiple tiers, aggregate payment
caps over multiple payments, and/or catch-up and carry-forward features. The impact of the payoff
structure on risk depends on the proximity of the expected metric forecast relative to the various
thresholds, caps and other structural features, as well as on the volatility in growth for the metric and
the time remaining to settlement. For this reason, it is difficult to determine the impact of the payoff
structure on the discount rate for many real-world examples.
This is one of the key reasons why it is problematic to apply the SBM to the valuation of a nonlinear
payoff structure based on an earnout metric with non-diversifiable risk: it is hard to know what
discount rate to apply to adjust for the riskiness of the earnout cash flow. The next section introduces
a concept that helps the valuation specialist avoid this difficult assessment when using an option
pricing methodology.
4.6
Risk-Neutral Valuation
Many valuations involve discounting a stream of expected cash flow by an appropriately chosen
discount rate. A fundamental principle of valuation requires the chosen discount rate to accurately
capture the market participant view of the risk of the cash flow.
The simplest situation involves cash flows that are known and certain to be paid at different points in
time. In such a case, the discount rate need only capture the time value of money (and any counterparty
credit risk). The appropriate discount rate in this case is the risk-free rate plus any adjustment for
counterparty credit risk, 34 where both the risk-free rate and the credit spread are for a term
commensurate with the time from the valuation date to the expected date(s) of payment.
When the cash flows vary due to exposure to non-diversifiable sources of risk (e.g., revenue, EBITDA)
the discount rate should include a premium in addition to the risk-free rate plus counterparty credit
33 Implied discount rates are based on data as of September 30, 2013. Source: OptionMetrics, a provider of historical option price data.
34 Counterparty credit risk is discussed in Section 5.2.6.
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risk. This premium should be commensurate with the degree of non-diversifiable risk of the cash flow.
For example, in a CAPM framework such as that described in Section 4.3.1, the higher the correlation
of the cash flow with the market, the higher the premium over the risk-free rate.35
The CAPM framework provides one methodology for quantifying the risk premium associated with
the expected cash flow for an earnout with a linear structure. The product of the beta for the underlying
metric and the Market Risk Premium (plus, in an Adjusted CAPM framework, an appropriate portion
of any additional risk premiums) represents the Required Metric Risk Premium (RMRP) for the non-
diversifiable risk associated with the cash flow of that linearly-structured earnout. As discussed in
Section 5.2.3, the quantification of the RMRP incorporates the correlation between the earnout metric
and the market portfolio, volatility, and an appropriate portion of any additional risk premiums.
Importantly, however, the RMRP for a metric with non-diversifiable risk does not capture the impact
of any nonlinearities in the earnout payoff structure. As illustrated by the implied discount rates for
call options shown in Table 2 of Section 4.5, directly assessing the adjustment to the discount rate to
incorporate the impact on the risk premium of even a relatively simple nonlinear payoff structure can
be challenging.
Risk-neutral valuation provides a way to circumvent this issue.
As mentioned above, valuation is often accomplished by discounting a stream of expected cash flows
by (premium for non-diversifiable risk + risk-free rate), plus in the context of contingent consideration
valuation an adjustment for counterparty credit risk. An equivalent way to value cash flows is to first
remove the non-diversifiable risk from the expected cash flows, for example by reducing the projected
growth rate by the RMRP.36 Then the resulting “risk-neutral” expected cash flows are discounted at
the risk-free rate + adjustment for counterparty credit risk. This process is mathematically equivalent
to the usual discounting—it just happens in two steps. However, separating the discounting into these
two steps allows one to consider the impact of a nonlinear payoff structure on cash flows from which
the systematic risk has been removed. If there is no systematic risk in the cash flows, the payoff
structure cannot affect the amount of systematic risk and therefore the payoff structure does not affect
the magnitude of the required rate of return. Thus, in this context of risk-neutral expected cash flows,
there is no need to estimate the effect of a nonlinear structure on the discount rate.37
Similarly, in the context of contingent consideration, removing the non-diversifiable risk from the
metric forecast allows the valuation analysis to be performed in a risk-neutral framework. Once the
non-diversifiable risk has been removed from the forecast distribution for the metric, the payoff
structure (whether it is linear or nonlinear) no longer affects the required rate of return.
More specifically, contingent consideration valuation in a risk-neutral framework can be performed,
for example, using the following process:
35 Methods for estimating the risk premium when the metric is exposed to non-diversifiable risk are explained in Section 5.2.3.
36 There are two (equivalent) ways to risk-adjust expected cash flows to remove non-diversifiable risk: (1) subtract an amount
commensurate with the (non-diversifiable) risk or (2) discount by a risk premium commensurate with the (non-diversifiable) risk.
The latter is the more common method used by valuation specialists.
37 For a discussion of the mathematics underlying this result, see the textbook by Hull entitled Options, Futures, and Other
Derivatives, 8th ed., 2011, pp. 631-634.
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• Discount the expected case forecast of the metric by the RMRP (to create a risk-neutral
forecast) and assume an appropriate volatility for the metric, to construct a risk-neutral
distribution of outcomes for the metric38;
• From the risk-neutral distribution of metric outcomes, calculate the (risk-neutral) contingent
consideration payoff distribution according to the terms of the contingent consideration
arrangement
• Compute the expected (risk-neutral) payoff, from that (risk-neutral) payoff distribution
• Discount the expected (risk-neutral) payoff cash flow at the risk-free rate plus any adjustment
for counterparty credit risk.
To illustrate how risk-neutral valuation incorporates the impact of a nonlinear structure, consider an
earnout with a fixed payment of 100 if an EBITDA threshold of 2,000 is reached, i.e. a binary payoff
structure. Suppose for purposes of this example that management’s expected case (mean) EBITDA
forecast is equal to that threshold, as depicted by Figure 7. Adjusting for the RMRP (shifting the
distribution of EBITDA to the left) moves the risk-neutral expected (mean) EBITDA below the
threshold, as depicted by Figure 8. If the earnout were a fixed percentage of EBITDA (i.e. linear) then
the impact of the shift in distribution on the earnout would be the same as discounting at the RMRP.
However, in this example, the shift of the distribution potentially dramatically reduces the likelihood
of payment, reflecting the increased impact of systematic risk due to the nonlinear structure.
38 The lognormal distribution, which is commonly used in practice to represent the distribution of most financial metric outcomes, can
be specified with two parameters (a mean and a standard deviation). See Section 5.4.3 for a discussion of how to address cases for
which the metric distribution is known to be far from lognormally distributed.
VFR Valuation Advisory #4 - Valuation of Contingent Consideration
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FIGURE 7: EBITDA Distribution with Associated Earnout Payoff
FIGURE 8: Risk-Neutral EBITDA Distribution with Associated Earnout Payoff
888
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Section 9.4 demonstrates risk-neutral valuation in the context of valuing this type of binary payoff
structure. As can be seen by comparing the examples in Sections 9.1 and 9.4, the implied discount rate
for this nonlinear structure is more than twice the discount rate appropriate for a similar earnout with
a linear structure.
As we shall see in Section 5.4, this concept of removing the systematic risk so that the valuation can
be performed in a risk-neutral framework is crucial for the application of option pricing methods to
the valuation of contingent consideration when the underlying metric has non-diversifiable risk and
the payoff structure is nonlinear. The magnitude of the impact of any nonlinear structure on the
discount rate depends not only on the structure and the metric (as illustrated via the examples in
Chapter 9) but also on the assumptions for volatility and the positioning of the mean of the metric
forecast distribution relative to the payoff threshold. Risk-neutral valuation allows the valuation
specialist to avoid the difficulties of estimating an adjustment to the discount rate to address a nonlinear
contingent consideration payoff structure.
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Section 5: Valuation Methodologies
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In this section, we present methodologies and recommendations for the valuation of contingent
consideration. Although we touch briefly on the market approach and cost approach below, we will
primarily focus on the income approach, as (1) the other approaches do not consider future cash flows
and (2) contingent consideration is rarely traded and has no replacement cost.
5.1
Valuation Approaches: Income Approach, Market Approach, and Cost Approach
The three commonly used approaches to determine the value of an asset or liability are the income,
market, and cost approaches. The nature of the asset or liability being valued, as well as the availability
of information, determine which approach(es) will ultimately be used.
The income approach uses valuation methods to convert future cash flows to a single current (or
present) value. The measurement reflects current market expectations about those future cash flows
and their riskiness.
Given that the income approach incorporates future expectations, it is typically the approach used to
value contingent consideration. Two income approach methods the Working Group has observed
being used in practice for valuing contingent consideration are the Scenario Based Method (SBM, see
Section 5.3) and the Option Pricing Method (OPM, see Section 5.4). Other income approach methods
for the valuation of contingent consideration also may exist or be developed in the future.
A comparison of the advantages and disadvantages of the SBM and OPM is presented in Section 5.5
and the recommendations of the Working Group for the circumstances under which each methodology
is typically appropriate are provided in Section 5.6.
Monte Carlo simulation (see Sections 5.3.6 and 5.4.4) and binomial lattice models (see Section 5.4.5)
are examples of techniques that can be used in conjunction with either SBM or OPM. Section 5.6
provides the recommendations of the Working Group for the circumstances under which techniques
such as Monte Carlo simulation are typically appropriate.
The market approach uses prices and other relevant information generated by market transactions
involving identical or comparable assets or liabilities. Valuation methods consistent with the market
approach typically rely on observed ranges of market value multiples of key financial metrics derived
from a set of comparables. The selection of the appropriate multiple within the range requires
judgment, considering qualitative and quantitative factors specific to the measurement.
Given the nature of contingent consideration and the lack of an active trading market, the market
approach is rarely used to value contingent consideration. In rare cases, there may be traded securities
that are relevant (e.g., contingent value rights [CVRs]). However, the market for CVRs often exhibits
low trading volumes, trades between related parties, and/or perceived information asymmetries
(where, for example, sellers may be perceived to have more information about the likely outcomes
than most buyers.)39 The valuation specialist would need to consider these factors along with other
typical market approach reliability indicators to determine if the market approach is useful, even in
the rare case where market data on the value of contingent consideration is available.
The cost approach is based on the amount that currently would be required to replace the service
capacity of an asset (often referred to as current replacement cost). From the perspective of a market
participant seller, the price that would be received for the asset is based on the cost to a market
39 In most fair value measurements, buyers and sellers are assumed to be informed of relevant facts; information asymmetries are
assumed to be minimal. However, in the market for CVRs, perceived information asymmetries can be significant.
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participant buyer to acquire or construct a substitute asset of comparable utility, adjusted for
obsolescence.
Given that there often is no obvious way to estimate a replacement cost for a contingent consideration
arrangement and that the cost approach does not consider future expectations, it typically would not
be appropriate to use the cost approach to value contingent consideration.
The remainder of Section 5 will focus on the income approach to valuing contingent consideration.
5.2 Key Elements of an Income Approach to Contingent Consideration Valuation
Key elements of valuation using an income approach include:
• The expected (mean) cash flow
•
• The discount rate and Required Metric Risk Premium.
(For nonlinear payoff structures), the probability distribution around the mean cash flow
Because contingent consideration arrangements (1) often occur in situations where there is substantial
uncertainty about the future and in some of those cases the expected forecast is not close to the most
likely forecast, (2) often are based on non-traded financial metrics and (3) often include nonlinear
payoff structures, addressing these three elements can require significant effort.
The remainder of this section 5.2 will address the above three key contingent consideration valuation
elements as well as other elements of an income approach, including:
• The estimation of volatility in growth for the metric
• The mid-period discounting convention
• Counterparty credit risk and
• Multiple-currency structures.
5.2.1 Estimating Contingent Consideration Payment Cash Flows
There are several important differences between estimating the expected cash flows of a business and
of a contingent consideration arrangement.
First, the financial projections developed for the valuation of an earnout will be based on the
contractual definitions of the underlying metrics as specified in the earnout agreement. These
definitions may not coincide with the standard metric definitions used to value a business. The
definitions of the earnout metrics might be designed, for example, to best motivate certain desirable
seller behavior, to better shift or allocate risk related to specific types of future performance, or to
minimize post-transaction disputes. For example, a revenue-based earnout may focus on the revenue
associated with only a key portion of the business or might have its own, idiosyncratic definition of
“revenue.”
Furthermore, because the earnout is valued from the perspective of a market participant buying or
selling the standalone earnout post-transaction (with the relevant business under the new ownership
of the actual buyer), the financial projections developed for valuing an earnout often include buyer-
specific synergies.40 In contrast, the financial projections developed for valuing an acquired business
40 See Section 4.1 for a discussion of the market participants for contingent consideration. Buyer-specific synergies are included in the
financial projections for valuing the earnout unless the relevant agreement specifically excludes such synergies from the definition
of the earnout metric. There are also situations in which the earnout agreement deliberately excludes market participant synergies;
in such situations, the earnout valuation might include fewer synergies than the valuation of the acquired business.
VFR Valuation Advisory #4 - Valuation of Contingent Consideration
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typically only include market participant synergies, excluding synergies that are unique to the buyer
and not available to other market participants.
Second, as discussed in Section 4.2, the estimation of the expected future contingent consideration
cash flow typically requires assumptions about the distribution of outcomes for the underlying metric.
There are two common methods used to develop the metric distribution assumptions.
One method is to develop future scenarios relevant to the underlying metric. The analysis would
include an estimation of the metric outcome under different scenarios and the scenario likelihood,
based on information known or knowable as of the measurement date. Assumptions about outcome
scenarios and their likelihoods may be based on, for example, analyses conducted by the parties during
the transaction process (e.g., in a deal model or board presentation), historical company or industry
experience (e.g., the observed track record of success in software integration for the buyer’s past
acquisitions or industry data on the probability that a new drug in a certain therapeutic area receives
regulatory approval) or management assessments.
An alternative method commonly used for estimating the distribution of future outcomes for financial
metrics is to start from the mean (probability-weighted, expected case) financial projections for the
business, for example, the expected case projections41 used to value the business or its intangibles. A
typical process would be for the valuation specialist to:
•
Identify the expected case projection for the relevant metric consistent with the expected case
cash flows of the business
• Adjust the metric projection if necessary to be consistent with the contractual definition of the
metric in the contingent consideration arrangement (including adjustment to include all
relevant buyer-specific synergies and to exclude any non-relevant market participant
synergies)
• Estimate the variance around the expected case projection of the metric
• Assume a metric probability distribution based on the metric’s estimated mean and variance.
A combination of these two methods might also be used in certain situations, for example to address
financial metric distributions that are difficult to represent with just a mean and variance due to the
impact of diversifiable events, such as the results of R&D (e.g., the performance of a new product
relative to its competitors). The valuation specialist often takes such diversifiable events into account
via probability-weighting the payoffs in various scenarios, as described in more detail in Sections 5.4.3
and 10.3.5.
Whichever method is being used to develop a distribution of metric outcomes, the reliability of each
data source should be considered and adjustments made as appropriate. For example, while a buyer’s
deal model might analyze only base case and downside scenarios if that was sufficient for the buyer
to gain comfort with the transaction, there may be relevant upside scenarios as well. Assumptions
based on historical experience may need to be adjusted for the facts and circumstances of the
transaction. As another example, management might assess that the potential variability of
performance around the base case is equal in all future years even though one might expect greater
variability in later years.
With respect to management assessments, the valuation specialist should consider using elicitation
procedures that minimize the known biases associated with probability assessments. Such known
41 The “expected case” is not the base case or most likely scenario. The expected case is the probability-weighted mean across the
potential outcomes.
VFR Valuation Advisory #4 - Valuation of Contingent Consideration
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biases include anchoring on recent results or a prior projection, overconfidence (failing to consider a
wide enough range of potential future outcomes), and conditioning estimates on hidden assumptions
(such as no competitive reactions to a new product introduction). 42 Debiasing techniques include
counteranchors, counterexamples, assessing multiple scenarios (e.g., high, middle and low cases),
contemplation of extreme scenarios, conducting pre-mortems, taking an outside perspective,
crosschecks, and decomposition, among others.43
A commonly observed error in the context of contingent consideration valuation is for management
to underestimate the range of outcomes for financial metrics such as revenue or EBITDA. For this
reason, the volatility in growth rate for the metric implied by management’s assessments is often tested
for consistency with (1) the historical volatility in growth rate for the metric of the acquired business
and/or comparable companies and (2) other risk measures such as the transaction IRR or acquired
business WACC.
Estimates of variance are often based on the historical volatility of the acquired business and/or
comparable companies, considering either (1) historical variability of growth rates for the relevant
metric, for example, variability in year-on-year quarterly growth in revenues or (2) historical
variability of equity prices, adjusted for financial and operational leverage of the relevant metric
relative to the long-term free cash flows to equity.44 However, care should be taken when using such
historical data to estimate the variance around the expected case projections. In many situations (e.g.,
the acquisition of a young business), the motivation for creating the earnout is that the metric outcome
is highly uncertain and therefore possibly more uncertain than implied by the historical data for public
comparable companies. Just as it is useful to check management’s assessments of variability around
the expected case against the comparable companies, so too it is useful to check the historical volatility
of the comparable companies against management’s assessments of potential upside and downside
scenarios.
1041
See Section 5.2.4 for detailed discussion of estimating volatility in growth rate for a metric.
1042
5.2.2 Discount Rate and Market Risk Considerations
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Contingent consideration payoffs are exposed to various types of risks. When selecting the discounting
for the contingent consideration valuation, the valuation specialist should consider:
• The time value of money – typically captured by the risk-free rate
• Counterparty credit risk, which represents the risk that the obligor will not be able to fulfill its
obligation if and when a payment becomes due
• Exposure to the non-diversifiable risk associated with the metric
• The impact on risk of the payoff structure.
The first two items on the above list (the time value of money plus a credit spread for the counterparty
credit risk) are applicable over the timeframe from the valuation date to the expected payment date(s).
However, the latter two risks (non-diversifiable risk and payoff structure risk) are applicable only over
the timeframe from the valuation date until the uncertainty associated with the metric is fully resolved.
42 See Tversky and Kahneman (1974), Judgement Under Uncertainty: Heuristics and Biases for a discussion of biases that influence
probability assessments and other judgements.
43 See, e.g., Montibeller and von Winterfeldt (2015) for best practices in eliciting outcome scenarios and risk assessments, including
debiasing techniques for minimizing both conscious and unconscious biases. See also Soll, Milkman and Payne (2015) for a
practical discussion of strategies for overcoming biases in thinking too narrowly about the future.
44 It should be noted that reliance on historical volatility of the metric or of equity prices only produces a proxy for volatility of the
earnout metric, as this data does not measure the volatility of metric growth relative to management’s forecast.
VFR Valuation Advisory #4 - Valuation of Contingent Consideration
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If, for example, the contingent consideration payoff depends on the level of revenue or earnings, such
financial metrics are typically exposed to systematic risk only until the time at which the uncertainty
is resolved, i.e., until the metric outcome, and hence the payoff amount, is known. However, even after
the uncertainty about a payoff amount is resolved, the discounting should incorporate the time value
of money and a premium for any exposure to counterparty credit risk until the date the payment is
made. Systematic risk is the primary subject of this section. See Section 5.2.6 for a discussion of
counterparty credit risk.
An earnout metric can be exposed to non-diversifiable risk, diversifiable risk, or both. The level of
exposure varies depending on the nature of the metric. The risk of certain nonfinancial milestone
contingent consideration structures, where a payment is made upon occurrence of a company-specific
event largely unrelated to market dynamics, would likely be considered predominantly diversifiable.
In contrast, contingent consideration payments based on a company’s revenue or earnings that depend
on the general economy, and are therefore correlated with market movements, would include a higher
level of systematic risk.
The Required Metric Risk Premium (RMRP) is a measure of the excess return above the risk-free rate,
or risk premium, that investors demand to bear the non-diversifiable risk associated with a metric.
While our discussion of how to estimate the RMRP is set within the Adjusted CAPM framework
introduced in Section 4.3.1 because that framework is commonly used in practice, the same principles
would apply if one is using an alternative framework for capturing systematic risk.
It is useful to begin a discussion of estimating the RMRP associated with an earnout metric with a
discussion of estimating the RMRP applicable to long-term free cash flows to equity (LTFCFE), for
which there are well-established and widely used methods, derived from the estimate of the cost of
equity. We have the following standard definition (including the potential additional premiums as
discussed in Section 4.3.1):
Where:
𝑅𝑅𝑀𝑀𝑅𝑅𝑀𝑀𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 = 𝑅𝑅𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 − 𝐿𝐿𝐿𝐿𝑅𝑅𝑅𝑅𝑅𝑅 = 𝛽𝛽𝐿𝐿𝐸𝐸𝐸𝐸𝐸𝐸𝑀𝑀𝐸𝐸 × 𝑀𝑀𝑅𝑅𝑀𝑀 + 𝐴𝐴𝑀𝑀
RMRPLTFCFE = the Required Metric Risk Premium for LTFCFE
RLTFCFE = the required rate of return (i.e., discount rate) for LTFCFE
LTRFR = the long-term risk-free rate
βEquity = the beta of the equity capital needed to generate the LTFCFE
MRP = Market Risk Premium
AP = Additional premiums (e.g., size premiums, country risk premiums, and company-specific
premiums as discussed in Section 4.3.1)
Since earnouts based on the long-term free cash flows to equity are rare, one generally needs to modify
the estimate to account for the specific risk and return characteristics of the earnout metric.
The above framework can be generalized to estimate the RMRP for the earnout metric (such as short-
term EBITDA or revenue), as follows:
Where:
𝑅𝑅𝑀𝑀𝑅𝑅𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝐸𝐸𝑀𝑀 = 𝑅𝑅𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝐸𝐸𝑀𝑀 − 𝑅𝑅𝑀𝑀𝑀𝑀𝐿𝐿𝑀𝑀 ≈ 𝛽𝛽𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝐸𝐸𝑀𝑀 × 𝑀𝑀𝑅𝑅𝑀𝑀
45
+ 𝐴𝐴𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝐸𝐸𝑀𝑀
45 This formulation does not incorporate the impact that debt financing might have on the RMRP for the earnout metric. The valuation
specialist should consider whether any adjustments are needed.
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RMRPMetric = the Required Metric Risk Premium for the metric
RMetric = the required rate of return (i.e. discount rate) for the metric
RMRFR = the risk-free rate over a term consistent with the metric exposure timeframe
βMetric = the beta of the metric
MRP = the Market Risk Premium
= the portion of the additional risk premiums applicable to the earnout metric
The bottom-up method of estimating the RMRP (described in Section 5.2.3) relies on this framework.
𝐴𝐴𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝐸𝐸𝑀𝑀
An alternative starting point for estimating the RMRP is the risk premium applicable to long-term free
cash flows to the firm (LTFCFF), for which there are also well-established and widely used estimation
methods. To estimate the RMRP for the earnout metric, the estimated RMRP applicable to LTFCFF
is modified to account for differences between the specific risk and return characteristics of the earnout
metric (such as short-term EBITDA or revenue) as follows:
Where:
𝑅𝑅𝑀𝑀𝑅𝑅𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝐸𝐸𝑀𝑀 = 𝑅𝑅𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝐸𝐸𝑀𝑀 − 𝑅𝑅𝑀𝑀𝑀𝑀𝐿𝐿𝑀𝑀 = 𝑅𝑅𝑀𝑀𝑅𝑅𝑀𝑀𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 × AF𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝐸𝐸𝑀𝑀 ≈ (𝑊𝑊𝐴𝐴𝐶𝐶𝐶𝐶
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− 𝐿𝐿𝐿𝐿𝑅𝑅𝑅𝑅𝑅𝑅) × AF𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝐸𝐸𝑀𝑀
RMRPMetric = the Required Metric Risk Premium for the metric
RMetric = the required rate of return (i.e. discount rate) for the metric
RMRFR = the risk-free rate over a term consistent with the metric exposure timeframe
RMRPLTFCFF = the Required Metric Risk Premium for LTFCFF
LTRFR = the long-term risk-free rate
= the adjustment factor required to account for the differences in risk between
LTFCFF and the earnout metric47
𝐴𝐴𝑅𝑅𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝐸𝐸𝑀𝑀
WACC = the weighted average cost of capital for the earnout-relevant business
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The top-down method of estimating the RMRP (described in Section 5.2.3) relies on this framework.
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As can be seen from the equations for
and RMRPMetric, no matter which framework you
are using, the risk premium for a metric will often not be the same as the risk premium associated with
the long-term free cash flows to equity or to the firm. Therefore, even for an earnout with a linear
payoff structure, the earnout discount rate will often not be the same as the IRR or the WACC for the
business.
𝑅𝑅𝑀𝑀𝑅𝑅𝑀𝑀𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
The structure of the earnout does not impact the estimation of the RMRP. Importantly, however, the
impact on the value of the earnout of applying the RMRP varies greatly based on the structure of the
earnout. If the payoff structure is linear, the systematic risk exposure can be easily captured by
46 This formulation explicitly incorporates the impact of the tax-related benefits associated with debt financing. The valuation
specialist should consider whether such benefits are applicable to the RMRP for the earnout metric and whether any adjustments are
needed.
47 As an example, adjustments for operational leverage and for duration would be required for a short-term revenue-based earnout
metric. An adjustment should also be considered for differences in risk between LTFCFF and for example, EBITDA, when there
are significant cash flow adjustments for, e.g., depreciation and amortization, capital expenditures, or working capital requirements.
The adjustment factor is often characterized as multiplicative when it is reasonable to adjust all risk premiums proportionately, but
it may take other forms when the various risk factors require disproportionate adjustments. See Section 5.2.3 for a more in-depth
discussion of methods of estimating the RMRP.
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discounting the future contingent consideration expected payoffs at the RMRP. However, as explained
in Sections 4.4, 4.5 and 4.6, estimating a discount rate for a nonlinear payoff structure exposed to
systematic risk is a challenge which can best be overcome by using a risk-neutral valuation framework.
Returning to the discussion of how to account for the specific risk and return characteristics of the
earnout metric, we note that estimation of the Market Risk Premium (MRP) has been well studied.
There are numerous publications that estimate the currently expected equity return required by the
market over and above the return associated with investments in risk-free securities.48 The market risk
premium that is estimated by using a broad-based index is typically considered a reasonable proxy for
the risk premium required by an investor for a diversified portfolio of investments. Estimating the
required premium associated with the metric’s risk (i.e., the RMRP), however, is not always as simple
a task.
Estimating the RMRP associated with the earnout metric requires consideration of (1) the systematic
risk factors associated with an investment in the metric (such as the correlation of the growth rate of
the metric with market returns, the volatility of the growth rate for the metric, and the volatility in the
rates of return required by investors for an investment with a duration matching that of the earnout49)
and (2) consistency with the rates at which comparable or related cash flows are being discounted for
other purposes (such as a valuation of the intangible assets acquired in the same transaction).50 At a
fundamental level, estimating the RMRP involves a quantification of the amount of risk associated
with an investment in the metric over the duration of the earnout.
It is important to consider how the contingent consideration metric relates to the cash flows generated
by the business. For instance, cash flows associated with the business are generally free cash flows,
whereas many earnouts are based on metrics related to earnings before interest and tax (EBIT),
EBITDA, revenue, etc. Each metric may have unique characteristics that impact the amount of
systematic risk as compared to the long-term free cash flows to equity or the firm due to, for example,
differences in financial and operational leverage or volatility.51
If there is no non-diversifiable risk associated with the metric, then the RMRP is zero. This situation
is common for earnouts based on nonfinancial milestone events with predominantly diversifiable risk,
such as the success of a research and development (R&D) effort, the ability to meet a deadline for a
software integration task, or the success in getting a specified percentage of the acquiree’s existing
customer base to agree to a contract modification in order to continue receiving services post-
acquisition. (See Section 9.3 for an example of the valuation of an earnout based on a nonfinancial
milestone event with predominantly diversifiable risk.) For financial metrics such as revenue or profit-
based metrics, the RMRP is typically not zero, and an adjustment for the non-diversifiable risk
associated with the metric is required.
48 See, for instance, Duff & Phelps’ estimation of the equity risk premium at https://www.duffandphelps.com/CostofCapital.
49 As for the value of an investment in equity, the value of the earnout to a market participant is affected by two types of volatility: (1)
the volatility of the forecast for the earnout metric around the expected case and (2) the volatility in the rates of return required by
investors for an investment with a duration matching that of the earnout. The need to incorporate the second type of volatility may
be more apparent if one considers the replicating portfolio derivation of options pricing theory, whereby a combination of a risk-
free asset and the underlying security (whose value is affected both by changes in the forecast results and by changes in the
market’s required rates of return) is used to replicate the payoff of a financial derivative.
50 Consistency does not mean that the discount rates are identical or even similar. See Section 7.2 for a discussion of consistency
checks and some of the key differences between the valuation of a business or its intangibles and the valuation of contingent
consideration.
51 See, e.g., Sections 10.3.1, 10.3.2, and 10.3.3 for discussions of alternative methodologies for addressing how to take differences in
financial leverage, operational leverage, and volatility into account, when estimating a RMRP.
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A financial metric-based beta, such as an earnings-based beta or a revenue-based beta, is a measure of
the systematic risk associated with the future performance for that financial metric, in a CAPM
framework. While the literature on equity betas, asset betas, and the WACC is rather extensive,
estimating a revenue beta (or a RMRP for revenue) may be a less familiar undertaking for many
valuation specialists. Nevertheless, there are multiple methodologies that can be used for measuring
systematic risk even for a revenue metric.
Methods for estimating the RMRP for a financial metric are described in the next section, with
earnings-based metrics (such as EBITDA) and revenue used as illustrative examples of a financial
metric.
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5.2.3 Methods for Estimating the Required Metric Risk Premium
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The methods for estimating the RMRP (equivalently the methods for estimating the discount rate for
risk-adjusting the metric projections) associated with financial metrics can be divided into two broad
categories:
1. The top-down method typically starts with the estimated risk premium implied by the discount
rate for the long-term free cash flows to the firm (for example, the transaction IRR or the WACC
estimate – the long-term risk-free rate), which is then adjusted for the differences in risk between
the long-term free cash flows and the earnout metric. Adjustments are often made for the following
items:
a. The short-term nature of the earnout metric, potentially including differences in investor
volatility for short-term free cash flows as compared to long-term free cash flows
b. Differences in leverage52 between free cash flows and the earnout metric
c. Differences attributable to which synergies are included or excluded by the definition of
the earnout metric (for example, the inclusion of buyer-specific synergies)
d. Other differences in risk (e.g., if using an Adjusted CAPM framework, differences in the
size premium, country-risk premium, and company-specific premium) between the long-
term free cash flows of the relevant business and the earnout metric. For example, if starting
from a WACC derived from comparable public companies where for purposes of valuing
the business a size premium was added, adjustments might be made to incorporate the
portion of that size premium that is applicable to the earnout metric. As another example,
if starting from the IRR associated with the transaction for the relevant business,
adjustments might need to be made to remove the portion of the size premium (or any other
additional risk premiums) that is not applicable to the earnout metric.
2. The bottom-up method starts (in the Adjusted CAPM framework) by estimating the earnout
metric’s beta, based on (a) the volatility in growth of the metric relative to the volatility of a proxy
for the market and (b) the correlation between growth in the metric and in the market. Adjustments
are then made to incorporate the portion of the additional risk premiums (i.e., size premiums,
country-risk premiums, and company-specific premiums) applicable to the earnout metric.
Adjustments could also be considered for the availability of debt financing.
52 Financial leverage is typically accounted for in the WACC. Operational leverage is not accounted for in the WACC or IRR and
therefore top-down methods should adjust for operational leverage for a metric such as revenues. In addition, the valuation
specialist should consider whether there are other differences in leverage for the earnout metric as compared to the long-term free
cash flows. For example, depending on the earnout metric, adjustments might be considered if there are substantial differences in
leverage due to depreciation, amortization, capital expenditures, or working capital requirements.
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Figure 9 below illustrates these two methods for estimating the RMRP, in an Adjusted CAPM
framework. Figure 9 also illustrates that when starting with the WACC or IRR, the discount rate
appropriate for the metric replaces the long-term risk-free rate with a risk-free rate commensurate with
the duration of the earnout.
FIGURE 9: Illustration of Two Methods for Estimating the RMRP
Top-down method
Bottom-up method
Required
Metric Risk
Premium
RMRP
RMRP
RMRP
Risk-free
rate
LTRFR
MRFR
MRFR
RMRP
MRFR
RMRP
MRFR
RMRP
MRFR
Discount rate for
long-term free
cash flows to the
firm
Adjustments for
short-term, leverage,
and portion of add’l
premiums N/A for
earnout metric
Discount rate
applicable to
earnout metric
Based on RMRP
estimated directly
for earnout metric
Relevant portion
of additional risk
premiums
applicable to
earnout metric
Discount rate
applicable to
earnout metric
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The following example illustrates (in an Adjusted CAPM framework) how the top-down and bottom-
up methods can be used to estimate the RMRP associated with an earnout metric.
Example: Consider the following situation:
•
•
•
•
•
Long-term risk-free rate = 4%
Market Risk Premium = 5%
Equity beta for the business = 1.0
Size premium for the business = 10%
Debt/equity ratio = 0.
With this fact pattern, the WACC for the business could be estimated to be 19% (computed as
4% + 1.0×5% + 10%). The Required Metric Risk Premium for the long-term free cash flows
to the firm (RMRPLTFCFF)53 is 15% (computed as 1.0×5% + 10%, or equivalently, WACC –
long-term risk-free rate = 19% − 4%).
Now suppose that the earnout for this transaction is based on revenues over the next year. How
can the top-down and bottom-up methods be used to estimate the RMRP associated with this
earnout?
1. Top-Down Method:
The valuation specialist considers what adjustments are needed to the RMRPLTFCFF of 15% to
account for the differences in risk between the long-term free cash flows to the firm and the
short-term free cash flows over the earnout period. For the purposes of this example, assume
53 Note, as debt is assumed to be zero in this example, RMRP for the long-term free cash flows to the firm = RMRP for the long-term
free cash flows to equity = (WACC – long-term risk-free rate).
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that the valuation specialist concludes that no adjustments are needed for duration. Next, the
valuation specialist considers whether there are significant differences in financial leverage as
compared to the leverage taken into account by the WACC analysis. Assume for purposes of
this example that, after due consideration, the valuation specialist concludes that there are no
significant differences in risk caused by, for example, capital expenditures, depreciation,
amortization, or working capital requirements. In combination with the assumption of no debt,
this analysis leads the valuation specialist to conclude that no adjustments to the RMRPLTFCFF
are needed for financial leverage. Next, the valuation specialist estimates the operating
leverage ratio applicable to the first year of revenue post-close, perhaps using one of the
methods described in Section 10.3.2. For the purposes of this example, assume that the
leverage ratio estimate is 50%. After due consideration, the valuation specialist concludes that
it is appropriate to apply the leverage ratio adjustment to the entire risk premium, i.e.,
proportionately adjusting the market risk and size premiums that are applicable to the one-year
revenue metric. With these assumptions, the RMRP for one-year revenue is calculated as 15%
× 50% = 7.5%.
2. Bottom-Up Method:
The valuation specialist estimates the beta for one-year revenue, perhaps using one of the
methods described in Section 10.3.3, to be 0.5. Assume that after due consideration, the
valuation specialist concludes that it is appropriate to use the ratio of the revenue beta to the
equity beta (0.5÷1.0) to estimate the portion of the additional size premium applicable to the
one-year revenue metric (i.e., half the 10% size premium is applicable to the revenue metric).
Finally, because debt is zero in this example, the valuation specialist concludes that no further
adjustment is needed for the availability of debt financing. With these assumptions, the RMRP
for one-year revenue is also 7.5% (computed as 0.5×5% + 10%×50%).
Note also that, whether using a top-down or a bottom-up method, the risk-free rate used in the
remainder of the analysis will not be the long-term risk-free rate of 4% that is included in the
WACC for the business. The risk-free rate (and any counterparty credit risk premium, see
Section 5.2.6) used in the earnout valuation should be commensurate with the time period from
the valuation date to the expected payment date(s).
In both the top-down and bottom-up methods, consideration should be given to the extent to which
any additional risk premiums (e.g., size premiums, company-specific premiums, country risk
premiums or other additional premiums representing non-diversifiable risk) 54 incorporated in the
estimated WACC for the relevant business are applicable to the earnout metric. Typically, the
valuation specialist will consider the rationale for including each of the additional premiums in the
WACC build-up, and then assess whether and to what degree the same rationale applies to the risk
associated with the earnout metric. Sample considerations are provided below.
•
In assessing the portion of any size premium applicable to the earnout metric, one consideration
might be the extent to which the business relevant to the earnout is anticipated to be integrated
with the acquirer over the term of the earnout. The more integrated the business, the more the
size premium applicable to the RMRP would resemble the size premium for the acquirer’s
business (post-transaction).
54 Methods such as the Fama-French five-factor model (see Fama and French (2015)) include other measures of systematic risk. The
principles articulated in this Valuation Advisory should generally be applicable to any premiums intended to capture non-
diversifiable risk.
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• The portion of a company-specific premium applicable to the earnout metric can be
challenging to gauge. If there is support that the earnout metric is, for example, 20% less risky
than the long-term free cash flows of the related business, then including the additional
premiums used in the WACC proportionately reduced by 20% might be a reasonable and
practical methodology. However, if the company-specific premium is included in the WACC
solely to reflect the higher risk of aggressive projections for long-term future cash-flows (but
not higher risk over the course of the earnout period), then a lower company-specific premium
may be appropriate for the earnout metric’s RMRP. Similarly, if the rationale for the company-
specific premium is to address significant near-term risk or aggressive projections relevant to
the earnout metric over the earnout period, then including the full company-specific premium
may be appropriate for the earnout metric’s RMRP.
• For country risk premiums, in addition to the extent to which such a premium is relevant to the
earnout metric, another consideration might be whether the earnout payoff is derived from the
relevant countries in the same proportions as the long-term free cash flows for the business.
In the example provided earlier in this section, for the top-down method, the operating leverage ratio
adjustment proportionately reduced both the size premium and the market risk premium included in
the WACC. For the bottom-up method, the portion of the size premium deemed applicable to the
revenue metric was chosen to be proportional to the ratio of the revenue beta to the equity beta. When
there is no clear support for fully including or fully excluding an additional premium, it is not
uncommon for a valuation specialist to consider it reasonable to include a proportion of the additional
premium in accordance with the relative risk of the earnout metric and long-term free cash flows to
equity.
Given the above considerations regarding size, country-specific and company-specific premiums, the
additional premiums incorporated in an earnout metric’s Required Metric Risk Premium will generally
be less than or equal to the additional premiums associated with the long-term free cash flows of the
business. Similarly, due to financial and operational leverage and the typically shorter time horizon
for an earnout, the metric beta for an earnings-based or revenue-based earnout is also typically less
than the beta for the long-term free cash flows to equity. As a result, an earnout metric’s RMRP will
often be less than the risk premium built into the WACC minus the long-term risk-free rate (LTRFR)
for the related business.55 The earnout metric’s RMRP will generally be less than (WACC − LTRFR)
for a revenue-based metric, due to operational leverage. Even for an earnings-based metric such as
EBITDA, the earnout metric’s RMRP may be less than (WACC − LTRFR), due to the difference in
duration or, for example, when capital expenditures add significant leverage.
Ultimately, the objective is to estimate a RMRP that reflects the market participant view of the non-
diversifiable risk associated with the earnout metric, while ensuring consistency with the transaction
economics and market conditions as of the measurement date.
The next sections discuss the RMRP estimation process using the top-down and bottom-up methods
for two common contingent consideration financial metrics: earnings-based metrics and revenue-
based metrics. After the discussion of these RMRP estimation methodologies, this section concludes
55 An exception could occur, for example, if the expected earnout cash flow is riskier than the cash flows of the business from a market
participant point of view (e.g., due to the inclusion in the earnout of riskier buyer-specific synergies that are not included in the market
participant WACC for the business).
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with a discussion of whether and when to incorporate tax effects into the estimate of the RMRP for a
pre-tax metric.56
5.2.3.1 Top-down Methods for Earnings-Based RMRP Estimation
The top-down method for estimating an earnings-based RMRP such as EBIT typically57 starts with
the estimated risk premium implied by the discount rate for the long-term free cash flows to the firm
for the relevant business (i.e., typically the transaction IRR or the WACC for the business, less the
long-term risk-free rate), which is then adjusted for differences in duration and in leverage between
the long-term free cash flows to the firm and the earnout metric.58
Many methodologies for estimating earnings-based discount rates start with the assumption that the
risk associated with the earnings of the firm is reasonably comparable to the risk associated with the
underlying assets of the firm. In the CAPM framework,59 an asset beta (or “unlevered” equity beta,
i.e., unlevered to remove the effect of financial leverage) is assumed to be a reasonable proxy for an
EBIT beta. Furthermore, in many circumstances an EBIT beta is considered a reasonable
approximation for other earnings-based betas such as EBITDA betas.60 That is, in many circumstances
it is considered reasonable to assume that
βEBITDA·≈ βEBIT·≈ βAsset
61
In certain circumstances in which the leverage introduced by taxes and cash flow adjustments such as
tax depreciation and amortization, capital expenditures, and working capital requirements is minimal,
it may be considered a reasonable approximation to use the same RMRP implied by the discount rate
applied to the long-term free cash flows of the business (as estimated by, for instance, the WACC)62
as an estimate of the RMRP for EBITDA.
WACC − LTRFR·≈ RMRPEBITDA·≈ RMRPEBIT
However, in the less common situation when taxes are not linearly related to pre-tax earnings (e.g., if
there are substantial net operating losses or tax credits in some of the earnout years) or when there are
substantial cash flow adjustments due to, e.g., depreciation, amortization or capital expenditures over
the earnout timeframe, an adjustment may be required for the related difference in risk between an
56 Pre-tax earnings typically have comparable risk to post-tax earnings, although there are instances in which taxes introduce significant
financial leverage and therefore significant differences in risk, as explained in Section 5.2.3.7.
57 The top-down method could also start with the estimated risk premium implied by the discount rate for long-term free cash flows to
equity, which would require additional adjustments to account for financial leverage. See Section 10.3.1.
58 For simplicity of exposition, in this and similar succeeding sections, we will assume that the expected cash flow for the earnout has
been adjusted to reflect all relevant synergies (including any earnout-relevant buyer-specific synergies), and that there are no
differences in the metric risk due to any differences caused by the inclusion or exclusion of synergies in the calculation of the earnout
payoffs.
59 While the discussion of the adjustments to the RMRP in this section illustrates the concepts in the CAPM framework, the underlying
theory of adjusting for financial leverage in estimating an earnings-based RMRP should apply to most other models for quantifying
non-diversifiable risk. See Section 4.3.1 for a description of the CAPM framework and the Adjusted CAPM framework.
60 The approximate equivalence of the EBIT beta and the EBITDA beta generally holds, except when there are significant fixed
depreciation or amortization expenses. In such circumstances, the asset beta can be adjusted by using the de-levering techniques
described in Section 10.3.2, but instead of de-levering for fixed costs as compared to EBIT, the valuation specialist would instead
de-lever only for the fixed portion of depreciation or amortization in EBITDA as compared to EBIT. Alternatively, this distinction
can be captured directly using the bottom-up method. Similarly, while the asset beta is usually a reasonable approximation for the
EBIT beta, adjustments might be required for businesses with a significant amount of fixed capital expenditures.
61 More generally, when a business has both debt and equity funding, the long-term asset beta implied by the WACC may often be
approximated as (WACC – long-term risk-free rate) / MRP. Such an estimate of the asset beta assumes that the financial leverage
adjustments incorporated in the WACC are approximately comparable to the financial leverage adjustments required for the
relevant earnings-based metric (such as EBIT or EBITDA).
62 Such an estimate should already capture aspects of the financial leverage difference between free cash flows to equity and total free
cash flows.
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earnout metric such as EBIT and the long-term free cash flows to the firm. See Sections 10.3.1 and
10.3.2 for a discussion of de-leveraging methodologies that could be used to adjust for these types of
differences in risk.
As discussed in more detail in Section 5.2.3, in an Adjusted CAPM framework, only the portion of
any additional risk premiums included in the WACC for the relevant business (e.g., size premiums,
country-risk premiums, and company-specific premiums) that are applicable to the earnout metric over
the earnout period should be included in the RMRP.
When applying top-down methods, it is important to consider whether any adjustments may be
warranted to account for differences in the earnings metric for the earnout as compared to the long-
term free cash flows of the business. For instance, typically asset betas are based on estimates of long-
term equity betas, and as such relying on them produces estimates of long-term EBIT betas. However,
many earnouts are short term in nature. There is some empirical evidence that long-term betas may
generally be higher than short-term betas,63 consistent with the greater exposure in the long term to
the impact of shifts in macroeconomic drivers of the market.64 In cases where the earnout is short term,
each of the components of the WACC build-up can be replaced with short-term assumptions, thereby
at least partially adjusting for the short-term nature of the earnout metric versus the long-term free
cash flows of the business. However, short-term earnings-related results may also be more related to
idiosyncratic, largely diversifiable, company-specific factors that may be specific to the acquisition
(such as integration risks, timing of achievement of cost or cross-sell synergies, or timing of product
launch) than they are related to long-term earnings growth; further adjustments might be appropriate
in such a situation.
When applying top-down methods, it is also important to consider whether there are any differences
in risk due to differences in the definition of what is included in the earnout metric. For instance, an
earnings-based earnout metric that includes buyer-specific synergies may be riskier than the cash flows
excluding those synergies.
Adjustments could also be appropriate to address volatility-related issues associated with the short-
term nature of the earnout. For example, volatility might be lower (e.g., if a portion of the future results
will be derived from contracts already in place) or higher (e.g., if management has assessed an
unusually large uncertainty regarding future results) than implied by comparable company asset betas.
See Section 5.2.4 for a further discussion of volatility estimation.
Additionally, estimates of both the equity and asset betas include the volatility in returns required by
investors for investments in equity securities. Top-down methods that rely on the equity or asset beta
therefore assume that the risk characteristics (i.e., beta and volatility in a CAPM framework) for EBIT
are the same as the risk characteristics of a hypothetical security that generates EBIT, including the
volatility in returns required by investors for such securities. Since equities are typically longer-term
investments, and the volatility in the value investors place on investments generally increases with the
time horizon,65 this method can overestimate systematic risk for earnout metrics. The overestimate is
normally small for long-term earnouts, but may be significant for short-term earnouts. Furthermore,
an earnings metric such as EBIT is a flow variable66 that is earned over the course of the earnout
63 It is typically assumed that betas are mean-reverting and that the term structure of betas is flat.
64 See Allen, Myers, and Brealey, Principles of Corporate Finance, 11th ed. (2013), pp. 228-229.
65 For instance, there is significant volatility in U. S. treasury bonds with a 20-year remaining term, even though the underlying cash
flows associated with those treasury bonds are considered to be risk-free. However, this volatility drops dramatically as the remaining
term approaches zero, with e.g. negligible volatility for a 20-year U.S. treasury bond with one year remaining on its term.
66 A metric that is earned over a fixed time period (e.g., EBITDA or revenue for a year) is referred to as a flow variable. In contrast, a
stock variable includes all value to be received over an infinite future time horizon.
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period, whereas an equity value (from which the asset beta is derived) is a stock variable, i.e. a forward-
looking point estimate of the future value of returns on investment in the company. As just one
example of the impact of this difference on systematic risk and volatility, any new information that
substantially changes the long-term outlook for a business would affect the equity (and asset) value,
but unless that new information substantially affects earnings over the course of the earnout period,
the value of an earnout based on the flow variable EBIT would be less impacted or even possibly
unaffected. An adjustment could also be considered to account for these issues.
If, instead of starting with the WACC – long-term risk-free rate, the valuation specialist chooses to
start with the cost of equity, then an adjustment should be considered for financial leverage. There are
many methods for de-levering the equity risk premium to estimate the RMRP for earnings-based
metrics such as EBIT, including but not limited to:
• The Hamada Method
• The Modigliani-Miller Generalized Beta Method
• The Practitioners’ Method
• Volatility-Based Method.
See Section 10.3.1 for a discussion of the above de-levering methodologies and for considerations
when choosing among these methods for a specific valuation assignment.
5.2.3.2 Top-down Method for Revenue RMRP Estimation
The top-down method for estimating a revenue-based67 RMRP typically68 starts with the estimated
risk premium implied by the discount rate for the long-term free cash flows to the firm for the relevant
business (i.e., typically the transaction IRR or the WACC for the business, less the long-term risk-free
rate),69 which is then adjusted for differences in risk between the long-term free cash flows to the firm
and the revenue-based earnout metric over the earnout-relevant time horizon.
Many top-down methodologies start with the WACC less the long-term risk-free rate, make any
needed adjustments for duration and/or leverage differences as described in Section 5.2.3.1, and then
adjust for operational leverage to account for the impact of fixed costs. Such methods start with the
same assumptions used for discounting the cash flows of the business, ensuring a consistent starting
point and incorporating the appropriate adjustments for financial leverage.
In the CAPM framework,70 revenue betas can also be derived from estimated asset betas by adjusting
for the impact of fixed costs. This adjustment captures the impact of operational leverage in addition
to the financial leverage already captured by the asset beta.
As discussed in more detail in Section 5.2.3, in an Adjusted CAPM framework, only the portion of
any additional risk premiums included in the WACC for the relevant business (e.g., size premiums,
country-risk premiums, and company-specific premiums) that are applicable to the earnout metric over
the earnout period should be included in the RMRP.
67 While the discussion in the next few paragraphs focuses on revenue, similar points could be made for other metrics that are subject
to operational leverage, such as gross profit.
68 The top-down method could also start with the estimated risk premium implied by the discount rate for long-term free cash flows to
equity, which would require additional adjustments to account for financial leverage using, for example, methods such as those
described in Section 10.3.1.
69 For simplicity of exposition, we will assume that the expected long-term free cash flows to the firm have been adjusted to reflect all
relevant synergies, and that there are no differences in the metric risk due to any differences in synergies.
70 While the discussion in this section illustrates the concepts in a CAPM framework, the underlying theory of adjusting for operational
leverage should apply to most other methods for quantifying non-diversifiable risk for a revenue-based metric.
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When applying top-down methods, it is important to consider whether any additional adjustments may
be warranted to account for differences in the revenue metric as compared to the long-term free cash
flows of the business. For instance, typically asset betas (and the WACC) are based on estimates of
long-term equity betas, and as such adjusting them for operational leverage produces estimates of
long-term revenue betas. However, many earnouts are short term in nature. There is some empirical
evidence that long-term betas may be higher than short-term betas, 71 consistent with the greater
exposure in the long term to the impact of shifts in macroeconomic drivers of the market.72 In cases
where the earnout is short term, each of the components of the WACC build-up can be replaced with
short-term assumptions, thereby at least partially adjusting for the short-term nature of the earnout
metric versus the long-term free cash flows of the business. However, short-term revenue-related
results may also be more related to idiosyncratic, largely diversifiable, company-specific factors that
may be specific to the acquisition (such as integration risks, timing of cross-sell synergies, or timing
of product launch) than they are related to long-term earnings growth.
When applying top-down methods, it is also important to consider whether there are any differences
in risk due to differences in the definition of what is included in the earnout metric. For instance,
revenues that include buyer-specific synergies may be riskier than the revenues excluding those
synergies.
Adjustments could also be appropriate to address volatility-related issues associated with the short-
term nature of the earnout. For example, volatility might be lower (e.g., if a portion of the future
revenues will be derived from contracts already in place) or higher (e.g., if needed to address unusually
large uncertainty regarding future results) than implied by comparable company asset betas. See
Section 5.2.4 for a further discussion of volatility estimation.
Additionally, estimates of both the equity and asset betas (and of the WACC), which the top-down
methods can use as a starting point to estimate the RMRP for revenue, include the volatility in returns
required by investors for investments in equity securities. As discussed in more detail in Section
5.2.3.1, the top-down methods can therefore overestimate systematic risk for earnout metrics. The
overestimate is normally small for long-term earnouts, but may be significant for short-term earnouts.
While less well known than methods for estimating earnings-based RMRPs, there are methods for de-
levering the RMRP for an EBIT metric for operational leverage over the term of the earnout, including:
• The Fixed Costs vs. Assets Method
• Volatility-Based Method.
See Section 10.3.2 for a discussion of the above methodologies and for considerations when choosing
between these methods for a specific valuation assignment. A third method (the Modified Harris-
Pringle Method) is also discussed briefly in Section 10.3.2. However, the Working Group does not
recommend the Modified Harris-Pringle Method for the estimation of a revenue RMRP.
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5.2.3.3 Bottom-Up Method for Estimating RMRP for Earnings-Based or Revenue-Based Metrics
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The Required Metric Risk Premium for a financial metric can also be estimated from the bottom-up
by direct estimation, rather than by starting from (and adjusting as appropriate) the risk premium
appropriate to long-term free cash flows.
71 It is typically assumed that betas are mean-reverting and that the term structure of betas is flat.
72 See Allen, Myers, and Brealey, Principles of Corporate Finance, 11th ed. (2013), pp. 228-229.
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In the CAPM framework,73 a metric beta can be built up using estimates of the volatility of that metric
and of the correlation between the growth in that metric and the market.74 See Section 10.3.3 for more
information regarding the bottom-up method for estimating a beta for an earnout metric and Section
5.2.4 on estimating volatility.
As discussed in Section 5.2.3, only the portion of any additional risk premiums included in the WACC
for the relevant business (e.g., size premiums, country-risk premiums, and company-specific
premiums) that are applicable to the earnout metric over the earnout period should be incorporated in
the RMRP. For example, if a size premium was included in the WACC, then a portion of that size
premium will likely need to be included in the RMRP.
In circumstances where there is significant debt in the capital structure, the valuation specialist should
consider whether it would be appropriate to make an adjustment to the estimated RMRP due to the
impact of the availability of debt financing.
For earnings-based metrics, the bottom-up estimation of the RMRP using the underlying metric itself
allows for capturing the intricacies of the differences in risk associated with different types of earnings,
e.g., earnings before tax (EBT) vs. EBIT vs. EBITDA. However, estimation of an earnings-based beta
can be challenging. Early stage companies are often the subject of acquisitions involving earnouts,
and historical data for such companies can involve negative or very small positive earnings.
Comparing growth rates in such cases to market returns may not result in reasonable correlation
estimates. Nevertheless, one may be able to overcome these difficulties through careful selection of
comparable companies with earnings that are sufficiently positive.
For revenue-based earnouts, the bottom-up method allows for capturing the intricacies of the
differences in risk associated with different types of revenue (e.g., management fees versus
performance fees, the latter of which may be significantly more volatile).
For both revenue and earnings-based metrics, estimation of the correlation between growth in the
metric and growth in the market requires care. For example, there are some indications that the returns
in the stock market might be a leading indicator of revenue and earnings growth for certain industries,
which would indicate that one may need to investigate lagged effects to obtain a proper estimate of
correlation. As another example, if estimating correlation or volatility based on quarterly data, growth
in the metric for a quarter should be measured on a year-on-year basis, so that (predictable) seasonality
effects do not depress correlation estimates or inflate volatility estimates.
The bottom-up method can easily accommodate alternative methods for estimation of future volatility
into the RMRP, such as incorporating management assessments or historical differences between
forecasts and actual results. As discussed in Section 5.2.4, these two methods directly estimate the
desired quantity, which is the volatility of metric growth relative to management’s forecast. Other
methods, such as de-levering equity volatility (often used in top-down methods) or using historical
metric growth of comparable companies, only estimate a proxy for volatility of the earnout metric.
(They estimate the volatility of growth in the metric, not the volatility of metric growth relative to
management’s forecast.) Such a proxy estimate for volatility may not always produce reasonable
results.
73 While this discussion of the bottom-up method illustrates the concepts in the CAPM framework, the underlying theory of how to
develop a bottom-up, metric-appropriate discount rate should apply to most other methods for quantifying systematic risk.
74 See Hull, Options, Futures, and Other Derivatives, 8th ed. (2011), pp. 766-768.
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Finally, bottom-up methods do not include the volatility in returns required by investors and therefore
can result in an underestimate of systematic risk for earnouts. The underestimate is normally small for
short-term earnouts, but may be significant for long-term earnouts.
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5.2.3.4 Ensuring Reasonableness of the Concluded Required Metric Risk Premium
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Regardless of which method the valuation specialist uses to estimate a RMRP for a financial metric,
it is important to ensure that the concluded estimate is reasonable. Certain methodologies are subject
to potential measurement challenges or theoretical shortcomings, while others may require adjustment
for duration or differences in volatility or systematic risk between the starting point (equity risk
premium) and the earnout metric. When concluding on financial metric RMRPs, one should consider
how the RMRP compares to other discount rates used in the valuation.
• A comparison of the respective discount rates and the related risk factors (e.g., beta and any
additional risk premiums if working in an Adjusted CAPM framework) should confirm that
they are all reasonable relative to one another, and that the differences are reasonable relative
to differences in the underlying risk (e.g., leverage, duration, etc.)
• A high risk premium for the (WACC – long-term risk-free rate) is often associated with a
commensurately high RMRP for an earnings-related metric. While there could be reasons for
differences between the two (e.g., shorter duration, leverage differences, etc.), there should be
a reasonable explanation behind any significant difference.
• The RMRP for revenue would typically be less than the (WACC – long-term risk-free rate),
due to the removal of the effect of operational leverage. The estimated RMRP for revenue
during the earnout period could be far lower than the (WACC – long-term risk-free rate), but
if so there should be a reasonable explanation for why the systematic risk is so much lower for
the earnout metric (e.g., shorter duration, leverage, proportion of booked business, etc.)
If the earnout metric is tied to cash flows that differ from the cash flows generated by the
standalone acquired business, then the relative risk of those different cash flows should be
considered. For example, if the earnout metric over the earnout period is tied to performance
of a consolidated business unit into which the acquired entity is merged or is affected by buyer-
specific synergies,75 that different risk profile should be reflected in the estimate of the RMRP.
•
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• The top-down method typically starts with the transaction IRR or estimated WACC of the
relevant business, both of which have well-established measurement frameworks.
• The top-down method ensures consistency of a business valuation or transaction price with an
earnout that is based on the long-term free cash flows of the business. For example, the top-
down method ensures that the value of an earnout that is based on 10% of the free cash flows
of the business in perpetuity reconciles to 10% of the value of the business.
• The reference WACC/IRR have often been calculated for other purposes and are therefore
readily available.
• By starting with the reference IRR or WACC, the top-down method creates a bridge between
the RMRP and the discount rates used in the valuation of the relevant business.
75 See Section 4.1 for a discussion of buyer-specific synergies.
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Disadvantages of the Top-Down Method:
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• There is no well-established method for adjusting long-term discount rates or IRRs to reflect
the short-term nature of most earnouts. One might expect short-term betas, or IRRs from short-
term investments, typically to be lower than those estimated or implied by the transaction
IRR/WACC.
• There are challenges associated with measuring the operational leverage ratio used to de-lever
the risk premium associated with the long-term free cash flows to estimate the RMRP for
revenue-based metrics. Also, the general assumptions used to de-lever for financial leverage
may not be appropriate when adjusting for operational leverage. In particular, the methods
used to de-lever the RMRP for long-term free cash flows for financial leverage often assume
that correlation with the market is not affected by leverage.
• The top-down method typically uses adjusted risk characteristics of equity prices as a proxy to
measure the risk characteristics of the earnout metric. While the use of equity prices to estimate
risk characteristics is widely accepted when discounting a stream of long-term, perpetual free
cash flows, it may not be suitable when the underlying metric is a short-term subset of free
cash flows.
• The top-down method assumes that the three main differences between the long-term free cash
flows of the relevant business and the underlying metric are differences in term, financial
leverage and operational leverage. The impact of other differences, such as the intricacies of
differences in risk associated with different types of earnings (e.g., EBT vs. EBIT vs.
EBITDA), may not be adequately captured using the top-down method.
• Additional adjustments may be required to achieve consistency with the situation-specific
volatility of the underlying metric in the short term (especially in the case of higher-than-usual
uncertainty, which is common for earnout metrics).
• The disadvantages of the top-down method are more prominent for revenue-based earnouts,
due to the relative difficulty of estimating the magnitude of and adjusting for operating
leverage.
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• The bottom-up method is flexible in that it can cater to any underlying metric that has
sufficiently reliable historical data. It can, for example, quantify the differences in risk
associated with different types of earnings (e.g., EBT vs. EBIT vs. EBITDA) or different types
of revenue (e.g., management fees vs. performance fees).
• The procedure for calculating the RMRP of the underlying metric is reasonably straightforward
and is similar to the well-established procedure for calculating historical equity betas.
• The bottom-up method can directly measure the risk characteristics of the relevant metric using
historical data, facilitating the recognition of any necessary adjustments to ensure consistency
with the situation-specific volatility of the underlying metric, including the flow variable nature
of a metric.
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• The bottom-up method can easily accommodate alternative methods for estimation of future
volatility into the RMRP, such as incorporating management assessments or historical
differences between forecasts and actual results.76
Disadvantages of the Bottom-up Method:
• Estimating betas based on historical growth in financial metrics versus the market is not widely
used or well researched.
• There may be measurement challenges associated with estimating betas using historical
financial metrics, including:
o Accounting anomalies associated with financial metrics (particularly for earnings metrics)
o A mismatch between historical financial metrics that reflect realized historical results
versus the value of market indices that reflect forward looking (future) expectations by
investors77
o Historical experience might need adjustment for the facts and circumstances of the
situation (e.g., sometimes the factors that drive the parties to put an earnout in place imply
that the outcome is more [or less] uncertain than historical results);
o The need to estimate appropriate time-lags to best fit the growth in realized financial
metrics to the growth in market indices.
• Beta estimates based on the bottom-up method exclude the volatility in required rates of return
of investors, and thus may underestimate the RMRP. The underestimate is typically small for
short-term earnouts, but an adjustment might be appropriate for long-term earnouts.
• Beta estimates based on the bottom-up method for the free cash flows of the firm are often
very different from betas estimated for the same free cash flows of the firm in the typical
WACC estimate. For example, the bottom-up method will typically result in a gap between the
value of an earnout that is based on 10% of the free cash flows of the business and 10% of the
value of the business. There is no well-established framework to bridge such a gap.
• The disadvantages of the bottom-up method are more prominent for earnings-based metrics,
as the earnings data for comparable companies is more prone to measurement issues such as
negative earnings and changes in accounting policies.
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5.2.3.7
Incorporating Tax Effects into the RMRP
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In deriving a discount rate for an earnout based on a pre-tax, financial metric (such as EBITDA or
revenue), adjustments for tax effects are not typically warranted because in most situations taxes do
not significantly impact risk, as they are linearly related to pre-tax earnings. For instance, if
corporate taxation is anticipated to be a fixed percentage of pre-tax profits (as is often the case), and
if pre-tax earnings are anticipated to have a de minimis likelihood of being negative (as is usually the
case for earnouts based on an earnings metric), a pre-tax earnings metric will not be subject to
substantially different leverage than the related post-tax earnings metric simply due to taxes.78 Under
76 Alternative methods for estimation of volatility are discussed in Section 5.2.4.
77 The Working Group is aware of efforts to address this issue by relying on historical data related to (forward looking) analyst
projections, rather than on historical outcomes. This type of research, if successfully completed, could partially mitigate this
disadvantage.
78 However, if (1) there is a significant chance of pre-tax earnings being negative, (2) there are significant net operating losses or tax
credits, (3) a large, fixed tax payment is anticipated, or (4) pre-tax and post-tax cash flows differ due to, for instance, the inclusion
or exclusion of large amounts of depreciation or amortization, then the relationship between pre-tax and post-tax earnings could be
nonlinear, especially over a short time horizon. In such a situation, an adjustment might need to be made to account for the resulting
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this assumption, taxes typically would not have a significant impact on systematic risk of the metric
(especially in the short term). In such cases, it would usually not be necessary to make a tax
adjustment to the Required Metric Risk Premium (or to the discount rate) for an earnout based on a
pre-tax financial metric.
Note that it is generally not appropriate to use what are often referred to as “pre-tax discount rates”
to capture tax effects in the context of the valuation of contingent consideration. Using a discounted
cash flow method to estimate the value of a business one can either discount post-tax expected cash
flows at a post-tax discount rate, or discount pre-tax expected cash flows at a pre-tax discount rate.
In the latter case, the higher pre-tax discount rate is used to compensate for the expected cash flows
excluding corporate tax to obtain an equivalent present value of the business. However, when
valuing an earnout, the valuation specialist is not attempting to obtain an equivalent present value of
after-tax cash flows, but instead is attempting to estimate the systematic risk applicable to the pre-tax
metric (e.g. revenue or EBITDA) itself. Therefore, it is not appropriate to apply a pre-tax discount
rate to the earnout metric, even if it is a pre-tax metric.
When applying a top-down method to estimate the RMRP, the valuation specialist should also consider
whether there are any tax effects that impact the discount rate for the business (e.g., the IRR for the
transaction) that would not impact the systematic risk associated with the underlying metric. For
example, there may be instances in which the transaction IRR is higher due to specific tax benefits
associated with the transaction. Any such tax-related increases in the discount rate should be removed
from the estimated RMRP for a pre-tax metric.
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5.2.4 Estimating Volatility
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Volatility is a key element for valuation of many contingent consideration arrangements. Whenever
the earnout has a nonlinear payoff structure, it is essential to quantify how much uncertainty there is
around the expected case forecast for the metric because (as explained in Section 4.2) the expected
payoff for the earnout will not be the same as the payoff at the expected outcome for the metric. In the
context of an option pricing model (discussed further in Section 5.4), this uncertainty is often captured
by estimating the volatility (or standard deviation)79 of the change in the underlying metric over an
appropriate length of time. In addition, some of the methods used to estimate the RMRP for an earnout
involve estimating the volatility of the earnout metric.
For an earnout with a nonlinear payoff, the volatility estimate can have a significant impact on value.
Consider the example in Section 9.5, in which the earnout payoff is 30% of the excess of the acquiree’s
annual EBITDA above 2,000 in the first year post-close. Assuming the other inputs remain the same
(which may or may not be reasonable, as a higher volatility would generally be related to a higher
RMRP), an increase in the volatility from 50% to 55% would increase the value of the earnout by
11.6% from 66.1 to 73.8, whereas a decrease in volatility from 50% to 45% would decrease the value
by 11.7% to 58.4. In general, the degree of sensitivity of the value to changes in the volatility
assumption will depend on where the expected case forecast is relative to the earnout thresholds and
caps (the moneyness of the earnout, as explained in Section 4.5) and the time remaining from the
valuation date to the end of the earnout period.
difference in risk. The methods discussed in Section 10.3.2 could be used to adjust the RMRP to address the differences in leverage
(and therefore risk) caused by any such nonlinearities.
79 Distributions typically used in practice, such as the lognormal distribution, have two parameters–a mean and standard deviation (or
volatility).
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There are numerous methods for estimating volatility associated with a metric, including:80
1. De-lever the historical and/or implied equity volatility of the subject company and/or
comparable companies (the “Deleveraging Equity Volatility Method”)
2. Rely on historical variability in the metric growth rate for the subject company and/or
comparable companies (the “Historical Metric Variability Method”)
3. Utilize management’s estimates of the potential variation in alternative future outcomes, in
conjunction with bias mitigation techniques (the “Management Assessment Method”).
The remainder of this section provides a more in-depth discussion of each of these methods, along
with a discussion of adjustments to the estimated volatility to account for any additional risks captured
in the RMRP, such as size premiums and/or company-specific risk premiums. The section concludes
with a discussion of how to cross-check the volatility estimate for reasonability.
5.2.4.1 The Deleveraging Equity Volatility Method
One way to estimate the volatility of the earnout metric is to begin with an annualized 81 equity
volatility based on the company’s (or comparable companies’) historical equity returns and/or implied
volatilities from traded options commensurate with the term of the earnout. Next, the equity volatility
is de-levered in the same fashion that betas are de-levered in the top-down methods presented in
Sections 10.3.1 and 10.3.2. For example, the equity volatility is de-levered for financial leverage for
EBIT-based earnouts, and is de-levered for both financial and operational leverage for revenue-based
earnouts.
Equity values, unlike most earnout metrics, are point estimates reflecting the total estimated future
value of the equity investment. Moreover, historical or implied equity volatilities are often annualized
to reflect the volatility of returns over a full year. However, most earnout metrics are exposed to risk
over the period during which they are earned, with the average exposure typically at the mid-period.
Therefore, if the volatility in growth rate for the metric is estimated by de-levering an annualized
equity volatility, the metric’s modelled risk exposure82 should be adjusted to reflect the period over
which the metric is earned. While the implementation of this adjustment can depend on the
methodology employed, typically the valuation specialist would incorporate the estimated volatility
in growth rate for the metric from the valuation date to the middle of the initial earnout period,
followed by the volatility from that mid-period to the mid-period of the second period, and so forth.
For example, if using Geometric Brownian Motion for an earnout based on revenue in each of the first
three years post-close, the valuation specialist might incorporate a half-year of volatility for the first
period and a full year of volatility for each of the second and third periods. See the example in Section
80 This list is not meant to be exhaustive. For instance, one alternative method for estimating volatility would be to rely on the differences
between historical analyst forecasts for comparable company performance as compared to actual results. Like the method that relies
on management’s assessments of alternative future outcomes, this method has the advantage of directly measuring the uncertainty
around a future forecast, i.e., it is a direct measurement of the desired input. However, adequate data might not be available to support
this method, analyst forecasts are developed with less information than is available to management (or to market participants), and it
might be difficult to adjust for any biases in analyst forecasts, as these might not be stable over time. If implementing this method,
care needs to be taken to align the timeframe for the forecast to the current forecast timeframe (e.g., an analyst forecast of calendar
year 2017 results as of December 31, 2016 would be comparable to a forecast as of deal close for Year 1 post-close) and to adjust for
(1) the information disparity between analyst and management forecasts and (2) the tendency for optimism in analyst forecasts.
Another method for estimating volatility around a forecast would be to rely on the differences between historical management
forecasts for performance of the earnout-relevant business as compared to actual results. However, adequate data is typically not
available to support a robust estimate using this method, and like all methods using historical data, past volatility might not provide
a good estimate of the volatility of the business post-transaction.
81 If starting from historical equity volatilities based on daily or weekly data, it is important to annualize the volatility estimate.
82 In an option pricing context, a typical model for the underlying metric assumes Geometric Brownian Motion, which has a time-
varying volatility assumption of σ2 × t where σ is an annualized volatility of returns/growth rates.
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9.10 for an illustration of this mid-period adjustment to the volatility estimated by deleveraging an
annualized equity volatility.
The resulting volatility estimate includes both the volatility of the growth rate for the metric and
volatility in returns required by investors. Since equities are typically longer-term investments, and
under normal circumstances the volatility in the value investors place on investments generally
increases with the time horizon, 83 this method typically overestimates volatility for short-term
earnouts.
Note also that this method only estimates a proxy for volatility of the earnout metric, and may not
always produce reasonable results, as it is attempting to measure volatility of growth in the metric, not
the volatility of metric growth relative to management’s forecast. The valuation specialist should
consider using the volatility implied by management’s assessments of multiple future scenarios (where
available and ideally after employing debiasing techniques, as discussed in Section 5.2.1) as a
reasonability cross-check. Such a check helps to guard against underestimates of volatility in cases of
higher uncertainty for the earnout-relevant business over the earnout timeframe than for the equity
prices of comparable companies.
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5.2.4.2 The Historical Metric Variability Method
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To estimate the volatility of the growth in the earnout metric, one can look at the historical standard
deviation in the metric growth for the company (or comparable companies84) and use this historical
evidence as guidance for an estimate for future metric growth rate volatility. Consideration should be
given as to how historical variation in the growth of the metric of the company (or comparable
companies) compares to the uncertainty around the expected case for the subject company’s metric.
For example, a company that has had historically steady growth rates may not provide a reasonable
comparable for estimating volatility for an earnout metric related to an early stage business anticipated
to evolve rapidly or to launch “bet the business” new products.
If historical volatilities based on year-on-year growth of the metric are used to estimate the volatility
of the earnout metric, then one has a direct estimate of the volatility over the course of a year, already
adjusted for the metric’s exposure to risk during that one-year period. To be consistent with the
estimation process, one should generally use a full period of volatility in historical metric growth.
(Using a half-period of volatility would underestimate the variation around the expected case.)
As for the Deleveraging Equity Volatility Method, the Historical Metric Variability Method only
estimates a proxy for the volatility of the earnout metric. It may not produce reasonable results in some
cases, as it assumes that the average growth rate in the metric is as good a predictor of next year’s
results as is management’s forecast. The valuation specialist should consider using the volatilities
implied by management’s assessments of multiple future scenarios (where available and ideally after
employing debiasing techniques, as discussed in Section 5.2.1) as a reasonability cross-check. Such a
check helps to guard against underestimates of volatility in cases of higher uncertainty for the earnout-
relevant business than historically for comparable companies.
83 For instance, there is significant volatility in U. S. treasury bonds with a 20-year remaining term, even though the underlying cash
flows associated with those treasury bonds are considered to be risk-free. However, this volatility drops dramatically as the
remaining term approaches zero, with negligible volatility for example, for a 20-year U.S. treasury bond with one year remaining on
its term.
84 Theoretically, if sufficient historical data is available for the subject company (or even better, if sufficient historical management
projections were also available), one could estimate volatility from subject company data. However, availability of adequate subject
company data is uncommon, the presence of the earnout agreement itself might signal greater than usual uncertainty around the
expected case forecast, and the requisite assumption that the subject company’s future volatility (post-transaction) will be similar to
its historical volatility may not be met.
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If relying on quarterly historical data to estimate volatility in growth rate for the metric, the valuation
specialist would typically use year-on-year quarterly growth (e.g., Q1 of the current year vs. Q1 of the
prior year) rather than quarter-on-quarter growth (e.g., Q1 of the current year vs. Q4 of the prior year)
to avoid having seasonality artificially impact the volatility estimates.
It may be necessary to adjust the historical volatilities to account for the risks specific to the metric
during the period of the earnout. For instance, if the metric-based earnout is short-term revenue and a
significant portion of the first-year revenue is reasonably certain due to contracts already in place, it
is possible that the first-year volatility should be less than the historical volatility. On the other hand,
if deal model scenarios indicate greater uncertainty related to potential outcomes for the acquired
company than has been observed historically for the comparables, or if the rationale for putting the
earnout into place is to share the risk associated with an unusually large uncertainty about the metric
outcome, it is possible that the volatility should be higher than that of the comparables.
The volatility estimate resulting from this method does not include any volatility in returns required
by investors and therefore may underestimate volatility.
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5.2.4.3 The Management Assessment Method
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A third method for estimating the volatility associated with an earnout is to utilize management’s
estimated variation in potential outcomes associated with high case and low case projections. One can
fit a distribution around assessments of high case, base case, and low case projections,85 and calculate
an implied volatility based on these assessments.
If management’s high, base and low case projections are used to estimate the volatility of an earnout
metric, a full period of volatility should be incorporated, as management’s assessments already take
into account that the metric is earned over the period. (Using a half-period of volatility would
underestimate the variation around the expected case.)
On the plus side, this volatility estimate is tied specifically to management’s forward-looking
estimated variation around the expected case, rather than to historical volatility that may or may not
be comparable to the risk of the metric over the earnout period. Indeed, if management’s assessments
imply a much higher volatility with a sound rationale, it is likely that historical or comparable company
analyses would underestimate the volatility in growth rate for the metric in the relevant timeframe.
Also, of the three volatility estimation methods discussed in this section, this method is the only one
that directly estimates the relevant volatility (variability around the expected case forecast) rather than
relying on a proxy (variability in the metric or in equity returns). As discussed above, the proxies relied
upon by the Deleveraging Equity Volatility Method and the Historical Metric Variability Method do
not always produce reasonable results.
On the downside, management assessments can be subject to certain well-known assessment biases,
including anchoring on recent results or a prior projection, overconfidence (failing to consider a wide
enough range of potential future outcomes), and conditioning estimates on hidden assumptions (such
as no competitive reactions to a new product introduction).86
To mitigate these potential issues, it can be useful to employ the probability assessment debiasing
techniques discussed in Section 5.2.1 and to compare the volatility estimates implied by management’s
assessments to historical subject company or comparable company data. For example, the volatility
85 A typical set of percentiles for which to obtain management assessments are the 10th percentile, expected case, and 90th percentile.
In the context of an option pricing model, the distribution typically fit is a lognormal distribution.
86 See Tversky and Kahneman (1974), Judgement Under Uncertainty: Heuristics and Biases for a discussion of biases that influence
probability assessments and other judgements.
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implied by management’s assessments generally shouldn’t be substantively less than the historical
metric growth rate volatility of comparable companies, without good reason (such as having an
unusually mature business or an unusually high proportion of business already booked.) Such a cross-
check helps to guard against management underestimates of volatility due to anchoring on the base
case or overconfidence.
Finally, the volatility estimate resulting from this method typically would not include any volatility in
returns required by investors and therefore may underestimate volatility.
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5.2.4.4 Adjusting Volatility for Additional Risk Premiums
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If the valuation specialist uses either of the first two methods (the Deleveraging Equity Volatility
Method or the Historical Metric Variability Method), it may be necessary to adjust the estimated
volatility to account for additional risks captured in the RMRP, such as size premiums and/or
company-specific risk premiums. For example, if the earnout-relevant business is a different size than
the comparable companies used to estimate volatility, adjustments may be required to factor in the
difference in volatility associated with the relative size of the business.87 Below are examples of a few
different techniques (not intended to be an exhaustive list) by which the valuation specialist might
choose to adjust volatility estimates to address differences in size between the earnout-relevant
business and the comparable companies used to estimate volatility.
• Select a volatility at a percentile of the range of comparable companies based on the size of
the earnout-relevant business relative to the size of the comparable companies. For example,
if the earnout-relevant business is smaller than the average company in the comparables list,
and the smaller companies in the comparables list tend to have higher volatility than the larger
companies on the list, one might select a volatility in the upper half of the range rather than the
median.
• Adjust the volatility estimate for each comparable company based on the following ratio:
(the RMRP including a size premium for the subject company)______
(the RMRP replacing the size premium with that for the comparable company).
For example, assume that the subject company has a RMRP of 10%, of which 5% is due to a
size premium. Assume there are three comparable companies, with corresponding size
premiums of 0%, 2.5%, and 5%. This method would adjust the volatilities for these companies
by 2x, 1.33x, and 1x, respectively.
• Adjust the volatility estimate for each comparable company based on broader empirical data
on the average volatility by size of companies. 88 More specifically, adjust the volatility
estimate for each comparable company by the following ratio:
(average volatility of companies in the size category for the earnout-relevant business)
(average volatility of companies in the size category for the comparable company).
If other additional risk premiums (such as company-specific risk premiums or country-specific risk
premiums) are included in the RMRP, consideration should be given as to whether to make a
corresponding adjustment to the volatility. For instance, depending on the rationale behind including
a company-specific risk premium in the RMRP, it may or may not be appropriate to adjust the
87 There is empirical evidence that smaller companies tend to have higher equity volatility than larger companies. See, for example,
Herr (2008), “Size Adjustments for Stock Return Volatilities.”
88 Sources of such empirical data include Grabowski et al. (2017) Valuation Handbook U.S. Guide to Cost of Capital and Valuation
Handbook International Guide to Cost of Capital.
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estimated volatility in growth rate for the metric. As an example, if the rationale for adding a company-
specific risk premium to the RMRP is that short-term revenues are highly uncertain due to the planned
launch of important new products, it would be appropriate to increase the estimated volatility to
address this additional source of variability around the expected case.
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5.2.4.5 Volatility Reasonability Cross-Checks
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Regardless of which volatility estimation method is selected, the valuation specialist should confirm
that the calculated volatility is reasonable given the underlying risk associated with the metric, and
therefore that the concluded volatility is consistent with the risk inherent in the estimated RMRP. For
instance, if working in a CAPM framework, one reasonability cross-check is to compare the assumed
volatility to the theoretical minimum volatility:
Where:
RMRP = the Required Metric Risk Premium
𝜎𝜎𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝐸𝐸𝑀𝑀 ≥ (𝑅𝑅𝑀𝑀𝑅𝑅𝑀𝑀 ÷ 𝑀𝑀𝑅𝑅𝑀𝑀) × 𝜎𝜎𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀
MRP = the Market Risk Premium
σMetric = the volatility of the growth in the metric
σMarket = the volatility of the return on a broad market index.
The equation above relies on the relationship between volatility and risk associated with the standard
CAPM measurement of beta. When working in an Adjusted CAPM framework, the assumption is that
this relationship extends to any additional risk premiums added to the traditional CAPM, which may
not be a reasonable extension of the CAPM conclusions. The cross-check also implicitly assumes that
the volatility in returns required by investors for a long-term investment should also be included in the
volatility in metric growth, which may not be reasonable for short-term earnout metrics. As such,
while it is useful to perform this cross-check, the relationship may not hold in all circumstances.
Similarly, regardless of which volatility estimation method is selected, the valuation specialist might
consider comparing the calculated volatility to the historical subject business experience with volatility
of actual results versus business plan forecasts (where available). Unless the earnout-relevant business
is substantially more mature or predictable than it had been historically, the variability around the base
case projections would often be expected to be at least as large as the historical variability of actual
results versus business plan forecasts.
As another possible cross-check, the valuation specialist might consider why the particular earnout
metric was chosen and, more generally, the rationale behind the earnout structure. For instance, if the
earnout was put in place in part to mitigate or share an unusually high risk, then the valuation specialist
should verify that the selected metric volatility is consistent with this fact pattern.
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5.2.5
In-Period Discounting Convention
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The practice of discounting cash flows using a mid-period convention is well known and widely used
as a practical approximation to allow for the time value and risk of financial metrics that are earned
over a period, as opposed to at a single point in time. For example, if forecast revenue earned for the
next year is estimated to be 100, discounting for a full year assumes that the entire 100 is earned at the
end of the period. Predicting the timing of when the revenue of 100 will be earned can be difficult,
and therefore valuation specialists often assume that, on average, the financial metric is earned at the
midpoint of the period to which it applies.
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Earnout payoffs based on financial metrics can be very risky and hence command very high discount
rates (for example, when the functional form of the earnout subjects the payoffs to significant
leverage). As such, the period convention applied when discounting can have a significant impact on
the value of the earnout.
For example, consider an earnout that has a payoff equal to 100% of the excess of future EBITDA
earned over the next year above 100:
• Payoff of earnout = Max(Future EBITDA in 1 year – 100, 0);
• Assume:
o Forecast (expected value) for EBITDA earned over 1 year = 120;
o Discount rate applicable to forecast 1-year EBITDA = 10%;
o Achievement of future of EBITDA of at least 100 is nearly certain;89
o 1-year risk-free rate = 1%.
The present value of this earnout can vary significantly depending on the in-period convention used
to discount EBITDA.90 To illustrate this concept, Table 3 below shows the impact of two different
period conventions on the value of the earnout: EBITDA is earned at the end of the year (full period)
or is earned on average at the middle of the year (i.e. mid-period). The analysis follows the procedure
discussed in Section 4.5.
TABLE 3: Example of the Impact of Full Period Versus Mid-Period Discounting
Period (p)
Full Period
Mid-Period
1.0
0.5
Value of 120
(120÷1.1p)
109.09
114.42
Value of 100
(100÷1.01p)
99.01
99.50
Earnout Value
10.08
14.99
In addition to the potentially significant impact that the in-period discounting convention can have on
the earnout value, it is important to maintain consistency throughout the analysis. If, for example, mid-
period discounting is used in the valuation of the business because the cash flows are earned on average
at the mid-point of each period, then mid-period discounting for the metric’s exposure to non-
diversifiable risk should also be maintained in an earnout valuation based on financial metrics that
similarly are earned on average at the mid-point of each measurement period specified for that earnout.
Note, however, that the earnout payment is made later, typically after the conclusion of the relevant
period for measuring the earnout metric. A mid-period convention is not used for discounting the
payment for the time value of money and any counterparty credit risk. Discounting the payment for
the time value of money and any counterparty credit risk uses the time horizon from the valuation date
to the expected payment date(s).
89 This assumption is only made so that the payoff can be assumed to be approximately linear, in order to illustrate the impact of in-
period discounting. The same results are obtained if we assume that EBITDA can be below 100, but assume that the payoff of the
earnout is strictly linear i.e. equal to Future EBITDA in 1 year – 100, (with no payment floor and a clawback if EBITDA is
negative). Since forecast EBITDA is risky and the threshold of 100 is contractual, the applicable discount rates are 10% and 1%,
respectively.
90 The in-period convention is only applicable to EBITDA and not to the contractual threshold of 100, because the threshold is a fixed
quantity, not subject to risk.
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5.2.6 Counterparty Credit Risk
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An earnout arrangement generally represents a contingent obligation to make future payments. As
such, the counterparty credit risk (or default risk) of the legal obligor (typically the buyer for an earnout
and the sellers for a clawback) should be considered, taking into account the seniority of the earnout
claim in the obligor’s capital structure and the expected timing of the payment. The obligor’s own
specific credit risk is considered in determining fair value (as opposed to the credit risk of a market
participant) because ASC 820 (and IFRS 13) presumes the contingent liability is transferred to a
market participant with a similar credit standing.91 Also, considering the fair value of the earnout from
the perspective of a market participant that holds the identical item as an asset, such a market
participant would consider the credit risk associated with the specific obligor (typically for an earnout,
the buyer) being able to make the future payments if and when they become payable.
An earnout often represents a subordinate, unsecured obligation of the buyer. To capture the time
value of money and non-performance risk, the valuation specialist would typically use a pre-tax cost
of debt that aligns with the term and seniority of the obligation. The seniority of the earnout payment
in the obligor’s capital structure should be evaluated based on discussions with management and/or a
review of the purchase documentation, because seniority can have a significant impact on the
counterparty credit risk.92
There are, however, mechanisms where the counterparty credit risk is either partially or fully
mitigated, including:
• Fully or partially funding the potential earnout obligation by depositing cash (or other
•
collateral) into an escrow account
Increasing the seniority and/or securitization of the obligation by structuring the earnout as a
note issued by the buyer, specifying the increased seniority ranking of the earnout obligation
• Obtaining a guarantee from a bank or other external party.93
There are also circumstances where the counterparty credit risk may be considered to have already
been incorporated (fully or partially) into the valuation through the allowance for the risk of the earnout
metric. These circumstances can arise where the earnout is based on the future performance of the
acquired business and in the (typically) upside scenarios in which the earnout is paid, the performance
of the acquired business is significantly positively correlated with the performance of the buyer, or
with the buyer’s ability to fulfill its obligation to pay the earnout. Such a situation is not typical, but
can arise when:
a) the acquired business represents a sizeable portion of the post-acquisition company
b) the acquired business is maintained as a separate entity that is responsible for the payment and
it is not guaranteed by the parent
91 ASC 820-10-35-17 states that “[t]he fair value of a liability reflects the effect of nonperformance risk. Nonperformance risk includes,
but may not be limited to, a reporting entity’s own credit risk. Nonperformance risk is assumed to be the same before and after the
transfer of the liability.” Similarly, per IFRS 13:42 “The fair value of a liability reflects the effect of non-performance risk. Non-
performance risk includes, but may not be limited to, an entity’s own credit risk (as defined in IFRS 7 Financial Instruments:
Disclosures). Non-performance risk is assumed to be the same before and after the transfer of the liability”.
92 In general, contingent consideration payoffs tend to be unsecured subordinated claims. However, this is not always spelled out in the
agreements. The valuation specialist should consider the impact of cross-default provisions, subordination, and explicit priority of
payment when selecting a credit spread.
93 Depending on facts and circumstances, credit risk mitigation mechanisms such as a guarantee by a third party may be accounted for
separately, rather than as part of the consideration transferred. The specific accounting rules for determining whether a credit risk
enhancement is a characteristic of the contingent consideration liability or asset are beyond the scope of this Valuation Advisory.
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c) the success of the acquired business is dependent on the success of the buyer’s business and/or
d) the success of the acquired business and the buyer are both largely driven by the same
uncertainty (for example, when both businesses do significantly better when the economy for
a certain industry or customer set is robust).
In such cases, the credit risk associated with the future payments may be lower in the upside scenarios
in which the earnout payments are due.
Example: A pre-revenue company acquires another pre-revenue company. The purchase
consideration includes an earnout with 5 million payable when annual revenues of the acquiree
reach 100 million. The acquirer’s cost of debt at the time of acquisition is very high. However,
the acquirer is likely to be in a significantly stronger financial position to pay 5 million upon
achieving 100 million of revenues. The counterparty credit risk used in the valuation of the
earnout should reflect this stronger position. For example, the counterparty credit risk could be
estimated assuming annual revenues of at least 100 million for the combined entity at the time
of payment.
The above discussion highlights the need to consider the counterparty credit risk associated with
making the future payments if and when they become payable. In rare cases, such as when the
contingent payment is a large multiple of revenue or EBITDA (perhaps intended to reflect the impact
on future value of the growth in business over the first few years), the obligation associated with the
payment of the earnout may even be large enough that it affects the creditworthiness of the obligor.
The form of payment of the earnout obligation may also affect the counterparty credit risk applied to
the valuation of the earnout obligation. For example, an earnout payment that is specified as a fixed
number of shares of the buyer’s common stock is unlikely to require an incremental allowance for the
buyer’s credit risk since the buyer will be able to use its shares as currency and satisfy the earnout
obligation regardless of the value of those shares.
As an alternative example of settlement in stock, if the earnout payment is specified as a monetary
amount that is settled in the form of the buyer’s common stock of equal value (i.e., the earnout payment
is settled in an equivalent variable number of shares of the buyer’s common stock), then the earnout
obligation is still subject to the buyer’s credit risk as if it were settled in cash. In this case, since the
earnout obligation is specified as a monetary amount, the form of the settlement does not impact credit
risk.
To summarize this section, when considering the amount of counterparty credit risk to incorporate in
the valuation of contingent consideration, issues to consider include the credit risk of the obligor over
the relevant timeframe, the seniority of the contingent consideration obligation in the obligor’s capital
structure, mitigation of non-payment risk via e.g. the use of an escrow account or guarantee, and the
correlation between the likelihood or amount of contingent consideration paid and the obligor’s ability
to pay (i.e., the obligor’s ability to pay in the scenarios in which the payment is due).
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5.2.7 Multiple-currency Structures
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Earnouts are often structured with performance thresholds, payment caps, and other features that are
contractually specified in monetary terms. Occasionally these features involve more than one currency
or are denominated in a different currency than is specified for the payment. For earnout arrangements
that span multiple currencies, one can often avoid the need to explicitly model future foreign exchange
rates by carefully choosing the currency in which the analysis is performed.
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Since the contractual terms of an earnout determine its future payoff, for earnouts that span multiple
currencies one needs to consider future foreign exchange rates when converting these monetary
contractual terms to another currency. Where the contractual terms have a linear relationship with the
earnout payment, one may be able to convert the contractual terms using the forward foreign exchange
rate 94 at the time of measurement. This is not true for contractual terms that have a nonlinear
relationship with the earnout payment (such as thresholds, caps, tiers, etc.), which would typically
require the use of a stochastic foreign exchange rate model to perform the currency conversion within
the valuation analysis. To avoid this complexity, the valuation analysis can be performed in the
currency in which the thresholds, caps, tiers and other contractual monetary terms (the nonlinear
structural features) of the earnout are specified.
Example: A U.S. company acquires a Brazilian company. If the revenue of the acquired
business exceeds 10 million Brazilian Real in the first year post-close, the sellers will receive
an earnout payment equal to 10% of the revenues above that threshold. However, the earnout
will be settled in equivalent U.S. Dollars (i.e. the payments are calculated in Brazilian Real
and then converted to equivalent U.S. Dollars as of the settlement date.)
The valuation analysis is typically more easily performed in Brazilian Real.95 The fair value
of the earnout can then be converted from Brazilian Real to U.S. Dollars, if necessary, at the
appropriate spot foreign exchange rate as of the measurement date.
Example: A German company acquires a U.S. company that produces revenue through
subsidiaries in the U.S. and Japan. The earnout will pay €1 million if the first-year post-close
revenues of the U.S. business exceed €10 million and the first-year post-close revenues of the
Japanese business exceed €5 million. The forecasts for the business are provided in U.S.
Dollars (for the U.S. subsidiary) and Japanese Yen (for the Japanese subsidiary.)
The valuation analysis is most easily performed by converting the revenue forecasts to the
currency of the structural feature that has a nonlinear effect on risk, i.e., the currency of the
thresholds, which are denominated in euros. Since revenue in dollars (or yen) converts linearly
to euros, one can convert the revenue forecasts to euros at the term-matched forward foreign
exchange rates. The valuation analysis is then performed entirely in euros.
There are rare cases when the parties to the transaction structure an earnout with the contractual
monetary terms (the nonlinear structural features) spanning multiple currencies. If the multiple
currency features do not interact with one another, the evaluation can be performed separately for each
country, in its own currency. However, if multiple currency features interact, for example through an
aggregate cap, additional complexities can arise. In such a case, the valuation specialist may need to
explicitly model future foreign exchange rates, to accurately capture the impact of the interaction.
Given the complexity involved in modeling future foreign exchange rates, the valuation specialist
should consider whether any such cross-currency exposure is likely to have a significant impact on
the earnout value.
94 The forward foreign exchange rate is equivalent to the (risk-neutral) expected future foreign exchange rate. In general, one can only
use the forward foreign exchange rate to convert an underlying metric from one currency to another, or to convert contractual terms
that have a linear impact on the earnout payment from one currency to another. For currencies that do not have liquid forward
markets, alternative methods may be needed. Typical approaches to estimate forward exchange rates are based on the relative
nominal interest rates or inflation rates in each respective currency.
95 If one were to perform the analysis in U.S. Dollars, then due to the nonlinear impact of the performance threshold, the valuation
specialist would need to consider a stochastic model for future foreign exchange rates to convert the performance threshold to U.S.
Dollars.
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When estimating the value of an earnout, the assumptions are currency-specific. For example, if the
earnout valuation analysis is carried out in Brazilian Real, the assumptions used in the analysis should
all be specific to Brazilian Real. That is, the metric forecasts should be denominated in Brazilian Real
and the volatility, RMRP (or discount rate), counterparty credit risk and risk-free rate should all be
estimated to be appropriate for Brazilian Real.
5.3
The Scenario-Based Method (SBM)
The SBM is a method under which the valuation specialist identifies multiple outcomes, probability-
weights the contingent consideration payoff under each outcome, and discounts the result at an
appropriate rate to arrive at the expected present value of the contingent consideration.
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The Working Group recommends the use of SBM for valuing contingent consideration when:
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a) The risk of the underlying metric is diversifiable, e.g., for achievement of diversifiable
nonfinancial milestones or
b) The payoff structure is linear (e.g., a fixed percentage of revenues or EBITDA with no
thresholds, caps, tiers, or carry-forwards).96
As described in more detail in Section 5.3.1, the Working Group does not recommend the use of SBM
for nonlinear payoff structures involving a contingent consideration metric with non-diversifiable risk.
The first step of the procedure for applying the SBM is relatively simple in concept. In each period
relevant to the earnout, the valuation specialist calculates the expected payoff as the weighted average
of the earnout payoffs across the possible scenarios for that period. The weights are equal to the
probabilities assigned to these possible scenarios. Identifying the scenarios and estimating the
probabilities can be a complex exercise, as discussed in more detail below.
In the second step of the procedure for applying the SBM, the valuation specialist discounts the
expected payoff. The SBM discount rate addresses the time value of money (risk-free rate) over the
relevant time horizon, the Required Metric Risk Premium, the impact of the earnout payoff structure
on risk, and any counterparty credit risk.
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The sections that follow address:
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• When the SBM is most appropriate
• Considerations for developing the scenarios and estimating the discount rate
• Applying the SBM to the valuation of a linear earnout payoff structure or a diversifiable
nonfinancial milestone payment
• Handling path dependencies or multiple interdependent metrics
• Conclusions about the use of SBM in the context of valuing contingent consideration.
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5.3.1 When the SBM is Most Appropriate
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The SBM is appropriate for pricing contingent consideration when:
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a) The risk of the underlying metric is largely diversifiable (e.g., nonfinancial metrics such as
achievement of regulatory approvals, degree of R&D success, resolution of legal disputes,
completion of a software integration project prior to a deadline, etc.) and/or
96 For payoff structures based on a fixed percentage of an earnings metric (for example, EBITDA), if there is a significant chance that
EBITDA will be negative and there is no clawback mechanism, then zero EBITDA serves as an implicit threshold, resulting in a
nonlinear payoff structure. However, if negative EBITDA outcomes have a de minimis impact on the expected payoff, it is
reasonable to assume such a structure is linear.
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b) There is a linear payoff structure.
In the case of a metric with only diversifiable risk, estimating the discount rate for the SBM is
relatively simple. In this case, the Required Metric Risk Premium will be zero (see Section 5.2.2). For
a metric with only diversifiable risk, the SBM discount rate need only address the time value of money
(risk-free rate) over the relevant time horizon and any counterparty credit risk.
In the case of a linear payoff structure, the structure does not change the risk of the underlying metric
(see Section 4.4). In this case, the discount rate must incorporate the Required Metric Risk Premium,
as well as the time value of money over the relevant time horizon and any counterparty credit risk.
In the case of a nonlinear payoff structure (for example, a structure with tiers, thresholds, caps, or path
dependencies such as carry-forwards, roll-backs or cumulative targets) involving a contingent
consideration metric with non-diversifiable risk, estimating the discount rate for the SBM is not at all
simple. In this situation, the SBM discount rate must be adjusted for the risk of that nonlinear payoff
structure—but the amount of the adjustment cannot be easily intuited by the valuation specialist.
Furthermore, the Working Group is not aware of any reasonable “rules of thumb” that would allow
the valuation specialist to gauge, in an objective manner and consistently across payoff structures, the
appropriate adjustments to the WACC, to the IRR, to the RMRP, or to any other discount rate
considered as a starting point to account for the impact on risk of a nonlinear payoff structure.97
The Working Group has observed attempts to estimate the discount rate to be applied to the expected
contingent consideration payoff in an SBM framework by “risk-adjusting” the WACC based on
identifiable features of the contingent consideration arrangement (e.g., credit risk and optionality risk).
Most often these adjustments are based on the valuation specialist’s subjective judgment and lead to
discount rates that do not appropriately account for the risk associated with a nonlinear payoff
structure.
Section 4.5 explains why selecting an appropriate discount rate in this situation is challenging to
implement correctly in an SBM framework. The examples in Chapter 9 further clarify the difficulty.
Even holding as much as possible about each example constant, the implied discount rate varies widely
with the structure, from 10% to 40% for the earnouts to -28% for the clawback (see Sections 9.1, 9.4,
9.5, 9.6, 9.10, and 9.11). Moreover, the magnitude of the impact of any nonlinear structure on the
discount rate depends not only on the structure and metric but also on the assumptions for volatility
and the positioning of the mean of the metric forecast distribution relative to the payoff threshold.
Table 2 in Section 4.5 illustrates this latter point. Varying the volatility and moneyness while keeping
the payoff structure the same, the discount rate in this table ranges from about 30% to well over 100%.
Due to the need to consider simultaneously the implications of the structure, the metric, the volatility,
and the positioning of the mean of the metric forecast distribution relative to the payoff threshold, the
Working Group believes that discount rate adjustments to account for nonlinear payoff structures in
an SBM framework are difficult to estimate quantitatively and even more difficult to justify
qualitatively.
For this reason, the Working Group does not recommend using the SBM for valuing contingent
consideration with nonlinear payoff structures involving metrics subject to non-diversifiable risks.
97 One could apply an OPM to back-solve for the discount rate, but if one is doing that, the use of the SBM is superfluous. The Working
Group is also aware of methodologies such as stochastic deflators (see, e.g. Jarvis (2001)) and the Wang transform (see, e.g., Wang
(2002)). However, these techniques can be complex to implement, negating the chief advantages of SBM—its simplicity and
transparency.
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5.3.2 Developing the Scenarios
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The valuation specialist’s primary goal when developing scenarios is to adequately represent the
metrics’ probability distribution over the relevant time period(s), considering the region of the
probability distribution that may require more granular consideration due to the nature of the payoff
structure. For example, it may be sufficient to only have two scenarios for a payment contingent upon
at least 80% of certain software development tasks being completed (in the first year post-close).
Meanwhile, an earnout with multiple tiers, for example, an earnout with differing levels of payment
for the first 80%, for the next 10% (between 80 and 90%), and for the final 10% (between 90 and
100%) of such software development tasks completed in the first year post-close, would require more
scenarios.
From a statistical standpoint, the more granular the scenarios the better. However, the valuation
specialist should balance the need for statistical accuracy with the additional subjectivity introduced
by estimating many scenarios and probabilities. One possibility is to fit a continuous distribution
around a small number of assessed scenarios in order to estimate the likelihood of outcomes falling in
between the discrete scenarios that have been assessed.
It is recommended that the valuation specialist rigorously examine management’s assessments,
challenge whether management has adequately considered both the probability of various scenarios as
well as a wide enough range of potential outcomes, and challenge the consistency of these scenarios
and probabilities with other assumptions in the analysis. As discussed in Section 7.1 and 7.2, care
should be taken that there is consistency between the scenarios, probabilities, and expected metric
outcomes used to value the earnout and the assumptions used to value the business, its intangibles and
any in-process research and development (IPR&D).
Section 5.2.1 provides a more in-depth discussion around developing the expected payoff cash flow,
including a discussion of elicitation procedures that can help to minimize the known biases associated
with management’s assessment of scenario probabilities.
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5.3.3 Discount Rate Considerations
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When estimating a discount rate, the valuation specialist should consider the time value of money, the
Required Metric Risk Premium, the impact of the earnout payoff structure on risk, and counterparty
credit risk. The goal for the valuation specialist is to select a discount rate that is commensurate with
a market participant view of the risks in the expected contingent consideration payoff.
Thus, the considerations for a discount rate for contingent consideration contain elements of the
following:
• The time value of money – typically captured by the risk-free rate
• Counterparty credit risk, which represents the risk that the obligor will not be able to fulfill its
obligation if and when a payment becomes due, as discussed in Section 5.2.6
• Required Metric Risk Premium – market participants require a premium in excess of the risk-
free rate that captures the metric’s exposure to systematic risk and the portion of any additional
risk premiums (e.g., size premiums, country-risk premiums, and company-specific premiums)
relevant to the contingent consideration metric, as discussed in Section 5.2.2
• The impact of the contingent consideration structure on risk, if the structure is nonlinear (see
Section 4.4).
The first two items on the above list (the time value of money and counterparty credit risk) are
applicable over the timeframe from the valuation date to the expected payment date(s). However, the
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latter two risks (RMRP and payoff structure risk) are applicable only over the timeframe from the
valuation date until the uncertainty associated with the metric is fully resolved.
Prior to the publication of this Valuation Advisory, many practitioners would select the WACC or the
IRR of the transaction as the discount rate for the expected contingent consideration payoff. The
selection of the WACC or IRR as the discount rate was typically justified by reasoning that if the
projected cash flows are subject to the risk of the acquiree’s business, then the contingent consideration
payoffs resulting from these cash flows are subject to the same risk. This argument is flawed for almost
all contingent consideration valuations.
First, if an earnout metric is not directly (and linearly) related to the value of the assets, then the WACC
(or IRR) will not correctly represent the risk profile of either the metric or the contingent consideration
payoff structure.98 Even for a linear earnout payoff structure, differences between the riskiness of the
long-term free cash flows for the business and the riskiness of the earnout metric should be reflected
in a difference between the discount rate for the business and the discount rate for the earnout. Issues
to address include differences in volatility, correlation with the market, financial and operational
leverage, additional risk premiums, and relevant timeframe. See Section 5.2.2 for a more detailed
discussion.
Second, when the scenarios in which payment occurs are more certain (typically, 90 to 100%
probability), the payments become more comparable to deferred payments, i.e., they are lower risk.
One might consider the context in which the contingent payoff was agreed to (e.g., a large entity
acquiring a smaller entity with the intention to delay a portion of the payment vs. the intention to share
the risk associated with the success of a young product line) when considering the level of certainty to
attribute to the payoff.
For additional discussion of the difficulty of estimating discount rates for use in an SBM when the
payment structure is nonlinear and the metric has non-diversifiable risk, see Section 4.5.
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5.3.4 Applying the SBM to a Linear Payoff Structure
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As discussed earlier, the SBM is appropriate, and often the simplest method, for valuing contingent
consideration arrangements with a linear payoff structure.
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Example Earnout Payoff Structure
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Company A will be required to pay 30% of the acquiree’s EBITDA earned over the following one-
year period. Assume the likelihood of EBITDA being negative is de minimis.99 The payment is due
three months after the end of the year.
Assumptions
Management provided estimates for future annual EBITDA under three scenarios.100 The outcomes
and corresponding probabilities are as follows:
Low scenario: 1,500 with probability 25%
98 Note that even if the WACC would be an appropriate discount rate for the metric (which it generally is not, due to differences in
duration and leverage between the earnout metric and the long-term free cash flows for the business), the WACC is still not an
appropriate rate to be used for discounting the contingent consideration payments, unless the payoff structure is linear. See Section
4.4.
99 If the likelihood of EBITDA being negative is substantial, and if there is no clawback of 30% for negative EBITDA, then the earnout
payoff structure would not be linear. In this case, OPM might be a more appropriate methodology.
100 For illustrative purposes, this example assumes three scenarios were considered by management. This is not meant to suggest that
three is always the correct number of scenarios to consider.
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Base scenario: 2,000 with probability 50%
High scenario: 2,500 with probability 25%
The RMRP associated with the acquiree’s EBITDA is 9.5%, the risk-free rate consistent with the
timeframe to payment of the earnout is 0.5% (so the discount rate applicable to future EBITDA is
10%), and the credit spread of Company A for a subordinated obligation such as this earnout is 3.0%
(all these rates are per annum, continuously compounded). We also assume that the correlation
between the acquiree’s business and Company A’s business post-acquisition is not so large that the
credit risk of Company A would be significantly affected by the success of the acquiree’s business.101
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Valuation Methodology
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Since the contingent consideration’s payoff function is linear, the SBM is appropriate. Moreover, the
implication of linearity is that the contingent consideration payoff has the same risk as the metric, in
this case EBITDA. Thus, ignoring counterparty credit risk, the discount rate that is applicable to future
EBITDA is also applicable to the contingent consideration payoff.
The first step of the valuation is to calculate the expected earnout payoff, as illustrated in Table 4
below.
TABLE 4: Calculating the Expected Earnout Payoff
Scenario
EBITDA
Earnout Payoff
Probability
(a)
(b) = 30% × (a)
(c)
Probability Weighted
Earnout Payoff
(d) = (b) × (c)
1,500.0
2,000.0
2,500.0
450.0
600.0
750.0
Low
Base
High
Total
25%
50%
25%
100%
112.5
300.0
187.5
600.0
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For this example, assume that the continuously compounded discount rate for a linear function of
EBITDA is estimated to be 10% per annum. Consistent with the valuation of the cash flows of the
business and the fact that EBITDA is earned over the course of the year, the present value is calculated
as of the mid-period. Thus, the equivalent risk-adjusted future value for this amount of EBITDA over
the one-year period is given by:
570.7 = 600 × exp(-10%×0.5)
However, the earnout is not paid out over the course of the year, i.e., it is not paid on average at the
mid-point of the year. The payoff happens 1.25 years after the valuation date. The present value of the
earnout cash flow therefore is calculated taking into account (1) the time value of money for the
additional 0.75 years from the mid-period to the payment date and (2) the credit spread of Company
101 This situation is uncommon but could happen, for example, if the acquiree’s business were large in comparison to Company A’s
business. See Section 5.2.6 for a discussion of counterparty credit risk.
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A, for the 1.25 years from the valuation date to the payment date:102
547.7 = 570.7 × exp(-0.5%×0.75) × exp(-3.0%×1.25)
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5.3.5 Applying the SBM to a Diversifiable Nonfinancial Milestone
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As discussed in Section 5.3.1, the SBM is appropriate and is often the simplest method for valuing
contingent consideration based on metrics that have no substantial systematic risk (i.e., in a CAPM
framework, metrics with a beta close to zero). Such metrics include technical milestones such as
achievement of product development targets and other idiosyncratic, diversifiable events not based on
financial metrics (e.g., resolution of legal disputes).
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Example Earnout Payoff Structure
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The acquiree has a drug under development and Company A (the buyer, a much larger company with
numerous drugs both launched and under development) will be required to pay the sellers an amount
of 2,000 in the event the acquiree’s drug currently under development receives regulatory approval
within a year. The payment is due three months after the end of the year.
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Assumptions
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Company A’s management estimates a probability of 50% that the acquiree’s drug currently under
development will receive regulatory approval within a year. The risk-free rate commensurate with the
time to payment of the earnout is 0.5% per annum (continuously compounded) and the credit spread
of Company A for a subordinated obligation such as this earnout is 3.0% per annum (continuously
compounded). We also assume that the credit risk of the much larger Company A will not be
significantly affected by the approval of the acquiree’s drug under development.
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Valuation Methodology
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Since the earnout metric’s risk is predominantly diversifiable, the SBM is appropriate. The implication
of the diversifiable metric (i.e., no systematic risk affects the payoff function) is that the discount rate
is the risk-free rate plus an adjustment for the credit risk of the obligor (in this case, Company A).
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The expected payoff at the end of the year is:
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1,000 = 2,000 × 50% + 0 × 50%
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The payment’s expected present value is calculated taking into account the credit risk of Company A:
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957.2 = 1,000 × exp(-(3.0% + 0.5%) × 1.25)
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5.3.6 Using Simulation to Handle Path Dependency or Multiple Interdependent Metrics in SBM
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As discussed in Section 3.2.2, earnout payoff structures that span multiple periods with features that
create path dependency or that involve multiple, interdependent metrics will often require the use of a
technique such as Monte Carlo simulation.103 Applied in the context of an earnout valuation, each
102 Equivalently, one could grow the value of the EBITDA (570.7) by a half year at the risk-free rate (0.5%) to get 572.2 (this is the
value after discounting for the Required Metric Risk Premium for EBITDA but before accounting for any of the time value of
money), then discount for the full 1.25 years by (risk-free rate + credit spread = 3.5%). The answer is the same.
103 An exception occurs if the path-dependency or multi-metric interdependent nature of the payoff structure is due to its dependence
in a relatively simple way on the outcome for a diversifiable metric. For example, if the likelihood of achieving a technical
milestone in year two depends on the degree of technical success achieved with respect to a year one technical milestone, the
analysis might only require the use of conditional or joint probabilities, rather than a simulation, to address the interdependency.
Similarly, for a payoff based on both revenues and technical success, if the expected revenues depend on the degree of technical
success achieved in year one, the analysis might only require the use of scenarios for year one technical success to address the
interdependency.
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iteration or trial of the Monte Carlo simulation draws a value from the assumed (joint) distribution for
each earnout metric, for each period of the earnout. As part of the specification of the joint distribution,
the valuation specialist must also estimate the correlation between outcomes from one period to the
next and/or the cross correlations among metrics.
The earnout payoffs are calculated based on the “path” for the simulated metrics and the contractual
terms of the earnout arrangement and are discounted to present value at a rate that reflects the risk
associated with the earnout payoffs (risk associated with the earnout metrics and structure, time value
of money, counterparty credit risk, etc., as explained in Section 5.2.2.) The value of the earnout is
estimated to be the average present value of the earnout payoffs over all iterations of the simulation.
Many iterations are typically required to get reliable results from a simulation. The standard error of
the simulation mean is a statistical measurement that can be used to determine how many iterations
are necessary.
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5.3.7 Conclusions Regarding SBM
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The main advantages of the SBM are its simplicity and transparency (when used appropriately), and
the relative ease of understanding the model and modifying the inputs. The main disadvantage of the
SBM is that estimating a discount rate adjustment to incorporate the impact on risk of a nonlinear
payoff structure for a metric with non-diversifiable risk is neither simple nor intuitive, nor is the
Working Group aware of any reasonable “rules of thumb” for such an adjustment.
For the above reasons, the Working Group recommends the use of SBM for valuing contingent
consideration when:
a) The risk of the underlying metric is diversifiable, e.g., for achievement of certain nonfinancial
milestone events or
b) The payoff structure is linear (e.g., a fixed percentage of revenues or EBITDA with no
thresholds, caps, tiers, or carry-forwards).
However, the Working Group does not recommend the use of SBM if the payoff structure has
thresholds, caps, tiers, carryforwards, or other significant nonlinearities and the risk of the underlying
metric is non-diversifiable.
5.4
The Option Pricing Method (OPM)
The purpose of this section is to describe the method recommended by the Working Group for use in
valuing contingent consideration for which the payoff structure is nonlinear and involves a metric or
event with non-diversifiable risk.104 As illustrated in Section 3.2.1, the payoff functions for common
contingent consideration arrangements that have a nonlinear structure are option-like (e.g., resemble
calls, caps, collars, cash-or-nothing, asset-or-nothing, etc. options) in that payments are triggered if
certain thresholds are met. Ample literature is available that supports the use of the OPM in pricing
instruments with nonlinear payoff functions. Some of the earliest contributions to the field of option
pricing theory are the papers by Louis Bachelier (1900), Robert C. Merton (1973), Fisher Black and
Myron Scholes (1973), and John C. Cox, Stephen A. Ross and Mark Rubinstein (1979). See Section
10.3.7 for a further discussion of the academic support for the use of option pricing methods for non-
traded metrics.
104 This section complements Section 5.3, which addressed the method recommended by the Working Group for use in valuing
contingent consideration based on metrics that have a linear payoff structure or for which the underlying risk is diversifiable— the
SBM.
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The essence of the OPM is to adjust the contingent consideration metric forecast for risk, or to create
a “risk-neutral” metric forecast, by applying a risk-adjusting discount rate to the metric forecast and
then to evaluate the contingent consideration payoff function using the risk-neutral framework (see
Section 4.6). Section 5.2.3 provides a discussion of how to estimate the Required Metric Risk Premium
for the metric. Once the metric forecast has been adjusted for risk, the expected contingent
consideration payoff is calculated based on the risk-neutral distribution (typically lognormal) of the
metric, and discounted at the risk-free rate plus any adjustment for counterparty credit risk105 from the
expected payment date(s) to the valuation date.
The OPM thus uses a risk-neutral framework to avoid the difficulties of estimating the adjustment to
the RMRP to address a nonlinear contingent consideration payoff structure.
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5.4.1 When the OPM is Most Appropriate
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The OPM is most appropriate for valuing contingent consideration with nonlinear payoff structures
that are based on metrics for which the underlying risk is non-diversifiable. In such cases, the OPM
provides a framework by which the impact of the payoff structure on the non-diversifiable risk of the
metric can be easily modeled.106 However, the OPM might add unnecessary complexity and
unnecessary assumptions (e.g., lognormal distribution) if the valuation specialist is valuing either (a)
an earnout with a linear payoff structure or (b) an earnout based on metrics with fully diversifiable
risks. In these two cases, an SBM may be simpler and will suffice.
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5.4.2 OPM Implementation in the Risk-Neutral Framework
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In the context of contingent consideration, the implementation of OPM requires a risk adjustment to
account for the fact that the metric (e.g., revenue, EBITDA, etc.) has non-diversifiable risk. See
Sections 4.3 and 4.6 for a discussion of non-diversifiable risk and risk-neutral valuation. See Sections
5.2.2 and 5.2.3 for a discussion of how to estimate the risk adjustment (i.e. the Required Metric Risk
Premium).
Management usually provides an expected (mean) forecast for the metric(s) over the earnout period.
These forecasts are adjusted for risk by applying a risk-adjusting discount rate107 commensurate with
the non-diversifiable risk embedded in each metric, and then used as an input into a closed-form
solution or a simulation depending on the payoff function. There are two equivalent ways to perform
this risk adjustment (also known as “forecast risk-adjustment methods”). Assuming for simplicity of
exposition a single time period, these two methods are:
1. Discount the metric forecast by a risk-adjusting discount rate to create a risk-neutral time zero
(or present) value of the metric. The time zero risk-neutral metric is then grown at the risk-free
rate over the considered time period; or
2. Adjust management’s forecasted growth rate of the metric over the considered time period
downward by the Required Metric Risk Premium.108
See Section 10.3.4 for a more detailed discussion of these two different ways of implementing forecast
risk-adjustment methods and their equivalence.
105 A discussion of counterparty credit risk is provided in Section 5.2.6.
106 As discussed in Section 5.3.1, due to the need to consider simultaneously the implications of the structure, the metric, the volatility,
and the positioning of the metric mean relative to the payoff threshold, it is difficult to estimate a discount rate for a nonlinear
payoff structure based on a non-diversifiable metric in an SBM framework.
107 Using continuous growth rates and continuously compounded discount rates is best practice when implementing OPM.
108 In some cases, this adjustment will make the growth rate negative.
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5.4.3 Using OPM When the Metric Distribution is Not Lognormal
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Typically, the OPM is implemented assuming a lognormal distribution or Geometric Brownian Motion
(GBM)109 for the earnout metric(s) due to mathematical tractability and ease of use. Section 10.3.5
provides a discussion of some common criticisms of the use of the lognormal distribution for financial
investments and notes its wide usage despite some of these criticisms being well-founded.
Although textbooks and other literature have addressed option pricing with non-traded underlying
metrics since at least the 1990s, the literature on the application of option pricing specifically to the
valuation of contingent consideration is limited; see Section 10.3.7 for a detailed discussion. However,
because (a) the application of the lognormal distribution to a company’s stock price is widely used in
practice, (b) alternative distributions for traded assets do not seem to provide significantly different
results,110 and (c) typical non-diversifiable earnout metrics such as EBITDA and revenue tend to be at
least somewhat correlated with a company’s equity value, GBM is typically also used for non-traded
financial metrics.
Revenue or EBITDA may not be lognormally distributed. As discussed below, many of the most
significant deviations from a lognormal distribution involve (a) diversifiable risks or (b) profit
outcomes that are negative—each of which can often be addressed in a straightforward manner in the
valuation. Setting aside these cases, the Working Group believes that the choice of using a lognormal
distribution for a financial (non-diversifiable) metric does not often significantly affect the valuation.
In the rare cases where the risk associated with the financial metric is non-diversifiable and the metric’s
distribution is known to be far from lognormally distributed in a manner that could significantly affect
the valuation, an adjustment may be appropriate. However, consideration should be given to the trade-
off between computational complexity vs. a more accurate representation of the real-world metric
distribution.
Fortunately, many of the most significant deviations between a lognormal distribution and the
distribution of typical (short-term, non-diversifiable, financial) earnout metrics are due to
contingencies related to diversifiable events. For example, future revenues might depend on whether
a key product development effort is very successful or only modestly successful. (Indeed, this might
be one of the prime reasons for putting the earnout in place—to allow the seller to share in the upside
and the buyer to mitigate the downside associated with this product development uncertainty.) In such
a situation, the valuation model can be separated into two different scenarios, each with their own
mean forecast and volatility (a higher mean for the “very successful” scenario in this example), and
with a management-assessed probability for each of the two possible resolutions of that diversifiable
risk. Similarly, if a closed-form model is appropriate, the results of two such closed-form models could
be weighted in proportion to the likelihood of these different scenarios for product development
success.
The second common issue with the lognormal assumption is that a lognormal distribution does not
capture outcomes below zero, which can occur with profit-based earnout metrics such as EBITDA or
EBIT. Fortunately, a typical profit-based earnout is generally only paid (or receives the vast majority
of its payoff) when profits are substantially positive—making it most important to correctly capture
109 See Section 10.3.6 for an in-depth discussion of the properties of a GBM, and suggestions for alternatives to consider when these
properties do not hold.
110 For traded shares or market indices, the use of GBM and its assumption of a lognormal distribution has become widely accepted
due to several academic papers published in peer-reviewed journals. These papers considered alternative distributions and/or
processes (e.g., arithmetic Brownian motion, jump-diffusion processes) with reported results that are not significantly different from
those obtained under the lognormal distribution assumption. The computational burden required for these alternative specifications
is, however, considerably increased.
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the likelihood of various upside outcomes. Thus, for earnouts, the overall impact of excluding negative
outcomes, or treating them as slightly positive, will not often be significant. In the rare cases (including
clawbacks) where contingent consideration is paid for negative profit outcomes or the impact of
excluding negative outcomes is significant, there are a few methodological solutions the valuation
specialist could apply.
Often the simplest technique to address significant negative earnings outcomes is for the valuation
specialist to convert the analysis to an alternative (but related) metric that is unlikely to go negative.
For example, the valuation specialist can apply an OPM using Monte Carlo simulation of future
revenues (assuming a lognormal distribution of revenues) and then estimate the profit associated with
the revenues and the corresponding contingent consideration payoff, in each simulation path. If
conversion to an alternative metric such as revenues is problematic, there are other techniques
available. Section 10.3.6 discusses these techniques, along with suggestions for addressing other, less
common issues, such as significant discrete drops or jumps in the metric distribution due to non-
diversifiable risks, and (for multi-time period earnouts) correlation over time that differs from that
implied by GBM, or time-varying volatility.
To summarize, in an OPM used to value an earnout, the distinction in riskiness between traded shares
and the (non-traded) earnout metric is captured by the difference between their respective required
risk premiums. However, the valuation specialist should also consider whether to explicitly address
any substantial difference between a lognormal distribution and the metric distribution.
5.4.4 Using Simulation to Handle Path Dependency or Multiple Interdependent Metrics in an
OPM
As discussed in Sections 3.2.2 and 3.2.3, contingent consideration structures that span multiple periods
with features that create path dependency or that involve multiple, interdependent non-diversifiable
metrics111 will generally require the use of a technique such as Monte Carlo simulation. Applied in the
context of an earnout valuation, each iteration or trial of the Monte Carlo simulation draws a value
from the assumed (joint) distribution for the metrics, for each period of the earnout. As part of the
specification of the joint distribution, the valuation specialist should consider what assumptions are
appropriate for the correlation between outcomes from one period to the next (if there is path
dependency) and for the correlation between metrics (if there are multiple, interdependent metrics).
For the correlation between outcomes from one period to the next, if a single GBM process is
employed, as is often the case for an OPM, the assumption is one of relatively strong positive period-
to-period correlation (more than 50%). As discussed in Section 10.3.6, the valuation specialist can
choose a different correlation by modeling each period as a separate GBM.
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For estimating the correlation between two or more metrics, the methods include:
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• Historical Metric Correlation Method: estimation based on the observed historical correlation
between the metric growth rates for the earnout-relevant business (where sufficient data is
available), for comparable companies, and/or for the industry. Adjustments can be made if the
future metric correlation is expected to differ from the historical relationship. For example, the
correlation between licensing revenue and maintenance revenue may change post-transaction
if the acquirer will modify the term of the license or maintenance contracts. Note that if using
111 If the structure involves dependencies only for example between a diversifiable metric and a non-diversifiable metric, this situation
can also sometimes be handled by creating outcome scenarios for the diversifiable metric, applying OPM within each scenario
(taking into account the impact of that scenario on the mean and volatility for the non-diversifiable metric), and weighting the
scenarios by their likelihoods to estimate the average risk-neutral payoff.
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quarterly data, the analysis should use year-on-year quarterly growth (e.g., Q1 of the current
year vs. Q1 of the prior year) rather than quarter-to-quarter growth (e.g., Q1 of the current year
vs. Q4 of the prior year) to avoid artificial impacts of seasonality on the correlation estimate.
• Management Assessment Method: estimation based on management’s assessment of the
correlation between metric growth rates. Direct assessment of correlation is challenging but is
often employed where adequate historical data does not exist, or where the metrics or the
company-specific correlation between them is unique. It is also good practice to use
management assessments as a cross-check. For example, it is appropriate to ask management
whether the observed historical correlation between the metrics is reasonable as an estimate
for the earnout-relevant business post-acquisition.
Once the correlation between the metrics has been estimated, the valuation specialist can incorporate
the correlation into the simulation.
Example: The buyer agrees to pay the sellers of an asset management company 10% of
management fees in excess of 100 million, and 15% of performance fees in excess of 40 million
in the first year after the acquisition, with an overall cap of 20 million. Historically, the
correlation in the growth of these two metrics for the subject company has been 50%.
Management agrees that 50% is a reasonable projection for the future correlation of growth in
these metrics. A Monte Carlo simulation is set up. For each iteration of the simulation, two
draws are made from a standard normal distribution, x1 and x2. The random draw used to
simulate management fees is x1 and the random draw used to simulate (the correlated)
performance fees is (0.5 × x1) + (x2 ×
).112
After risk-adjusting the metric forecasts to a risk-neutral framework, the earnout cash flow is
calculated based on the “path” for the simulated metrics and the contractual terms of the earnout
arrangement and are discounted from the expected payment date(s) to the valuation date at the risk-
free rate plus any adjustment for counterparty credit risk. The value of the earnout is estimated to be
the average present value of the earnout payments over all iterations of the simulation.
2
�1 − (0.5)
Many iterations are typically required to get reliable results from a simulation. The standard error of
the simulation mean is a statistical measurement that can be used to determine how many iterations
are necessary. See the example in Section 9.10 for an illustration of a Monte Carlo simulation in the
context of a multi-period earnout with a catch-up feature.
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5.4.5 Using a Binomial Lattice to Handle Buyer or Seller Choices
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As discussed in Section 3.2.4, earnouts may be structured with the ability of the buyer or seller to
make decisions over the term of the earnout that impact its payoff. In these cases, a binomial tree (or
more generally a lattice or finite-difference technique) can be used to incorporate optimal decisions
into the earnout valuation.
A binomial tree, whose branches represent potential future metric paths, is constructed based on
assumptions for future volatility in a risk-neutral framework. That is, the risk-neutral probability
distribution of future metric outcomes is modeled at successive time steps. The optimal decision
feature can then be incorporated by working backwards through the tree, from the end of the earnout
term to the valuation date, by minimizing (in the case of the buyer’s decision) or maximizing (in the
case of the seller’s decision) the expected present value of the payoff.
112 More generally, Cholesky decomposition can be used to simulate two or more correlated metrics. See Hull, Options, Futures, and
Other Derivatives, 8th ed. (2011), p. 450 for further detail.
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The use of a binomial tree is restrictive, however, since it may cause difficulties in addressing certain
path-dependent features. Valuing earnouts that have both path-dependent and optimal decision
features generally requires the use of a Monte Carlo simulation in conjunction with an algorithm to
address the buyer or seller decision for each iteration of the simulation.113
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5.4.6 Conclusions Regarding OPM
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The main advantage of the OPM is that the impact of the risk associated with a nonlinear payoff
structure based on a metric with non-diversifiable risk can be appropriately and readily incorporated
into the valuation using a risk-neutral framework. The main disadvantages of the OPM are its
complexity, lack of transparency, and that it is not widely understood. OPM also generally assumes a
lognormal assumption; substantive deviations from this assumption can be addressed when required,
but sometimes at the cost of additional complexity.
Therefore, the Working Group recommends the use of OPM for valuing contingent consideration if
the risk of the underlying metric is non-diversifiable AND the payoff structure is nonlinear (e.g., has
a threshold, cap, tiers, or carry-forwards). However, the Working Group recommends the simpler
SBM where there are no difficulties associated with estimating the impact on risk of the payoff
structure, i.e., when the payoff structure is linear or the risk of the underlying metric is diversifiable.
5.5
Comparison of SBM versus OPM
The SBM and OPM described in the preceding sections 5.3 and 5.4 are both applications of the income
approach, whereby the expected future earnout payments are discounted to the valuation date. Both
methods are similar in that they incorporate the Required Metric Risk Premium, time value of money,
and counterparty credit risk into their respective methodologies for discounting/adjusting for risk.
The differences between these methods relate to (a) the assumption about the distribution for the
growth rate of the earnout metric and (b) the way the risk associated with the payoff structure of the
earnout is incorporated into the valuation. OPM typically assumes that the growth rate of the earnout
metric is normally distributed 114 and the risk associated with the structure of the earnout is
incorporated into the valuation using a risk-neutral framework. SBM is more flexible about the
distribution for the growth rate of the earnout metric, but requires an assessment of the impact on risk
of the payoff structure—which is challenging when the payoff structure is nonlinear and the risk of
the underlying metric is non-diversifiable.
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A comparison of the SBM versus OPM is summarized in Table 5 below.
113 In some situations, the algorithm can be a relatively simple decision rule assessed by management. For more complex situations
such as a path-dependent early exercise option, there are many algorithms and techniques that have been developed. See for
example, F.A. Longstaff and E.S. Schwartz, “Valuing American options by simulation: A simple least-squares approach” (2001).
114 Equivalently, the method assumes that the underlying metric is lognormally distributed or follows a GBM process. However, as
discussed in Section 5.4.3, “lumpy” distributions caused by events with diversifiable risks can easily be incorporated into an OPM.
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Approach
Model for
Underlying Metric
TABLE 5: Comparison of SBM and OPM
Scenario-Based Method (SBM)
Income approach
Assessment of the distribution of
the underlying metric, based on
estimated
forecasts, scenarios,
and probabilities:
Option Pricing Method (OPM)
Income approach
Lognormal assumption for the
underlying metric distribution,
based on estimated forecasts and
volatility:
25
y
t
20
i
l
i
b
15
a
b
10
o
r
P
5
0
1
2
3
4
5
6
7
Scenarios for underlying metric
Underlying metric distribution
σ
Discount Rate /
Risk Adjustment
Metric Risk
Payoff Structure
Risk
Time Value of
Money
Counterparty
Credit Risk
(challenging
Required Metric Risk Premium
for
Assessment
nonlinear
structures
payoff
associated with non-diversifiable
risks)
Risk-free rate over relevant time
horizon until payment
Obligor’s credit spread
Required Metric Risk Premium
Built
framework115
into OPM’s risk-neutral
Risk-free rate over relevant time
horizon until payment
Obligor’s credit spread
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5.5.1 Advantages and Disadvantages of the SBM
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SBM Advantages:
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• The SBM is the simplest, most transparent and most appropriate model for earnouts where the
earnout metric does not have systematic risk or the payoff is linear.
• The SBM may be more consistent with how acquirers value earnouts when building deal
models that inform the consideration paid in the acquisition.
• The SBM is flexible in that it can easily model any distributional assumption for the underlying
metric, including distributions that are not lognormal, such as:
o Asymmetric outcomes – for example, when there are more downside than upside
possibilities (or vice versa) associated with a young business
o “Lumpy” distributions, based on varying levels of success or strength of competition
o Outcomes that cannot exceed certain levels due to capacity constraints
115 OPM implicitly accounts for the risk associated with the structure of the contingent consideration, there is no need for an explicit
additional adjustment to the discount rate for that risk. The RMRP is used to risk-adjust the forecast. See Section 10.3.4 for a
discussion of this procedure. By using a risk-neutral framework (see Section 4.6), OPM accounts for the risk associated with the
contingent consideration structure, regardless of how complex that structure is.
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o A beta distribution, which is useful for approximating the outcome of repeated trials with
a probability of winning – often the fundamental nature of revenue generation
o Negative earnings for earnouts based on earnings-based metrics.
• The SBM inputs (scenarios and probabilities) are generally provided by management and,
while relatively subjective, are easier for management to understand.
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SBM Disadvantages:
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• The impact of the risk associated with nonlinear payoff structures is often significant and
difficult to correctly assess qualitatively. Moreover, the Working Group is not aware of any
well-established framework to directly estimate the appropriate discount rate associated with
nonlinear payoff structures based on metrics with non-diversifiable risk.
• Estimating scenarios and probabilities (or a distribution) consistent with the valuation of the
business and its intangibles can be challenging.
• Given the qualitative (and in many cases subjective) nature of the input assumptions, the
valuation based on an SBM can be difficult to support and can be susceptible to biases that
underestimate risk.
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5.5.2 Advantages and Disadvantages of the OPM
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OPM Advantages:
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• The OPM is widely used to value financial instruments with nonlinear payoff structures similar
to nonlinear contingent consideration payoff structures.
• The impact of the risk associated with nonlinear payoff structures based on non-traded metrics
with non-diversifiable risk can be appropriately and readily incorporated into the valuation
using a risk-neutral framework.
• The volatility structure of a GBM is consistent with the typical assumption that the uncertainty
of future projections increases with time.
• The OPM has been extensively researched and there are widely used formulas to value many
of the payoffs typically used to structure earnouts.
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Disadvantages:
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• The OPM is less transparent and more difficult for management to understand than SBM.
• The OPM relies on complex mathematics and therefore OPM can be more costly and difficult
to implement for those not versed in option pricing theory.
• The growth of the underlying metric is generally assumed to follow a normal distribution,
which may not adequately fit the distribution of possible outcomes.116
• The implied discount rate associated with an OPM, and therefore the concluded fair value, can
be unintuitive and difficult to explain.
116 However, the diversifiable risks that typically drive lumpy distributions can be incorporated into an OPM, as described in Section
5.4.3.
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5.6
Summary of Key Recommendations Regarding the Valuation of Contingent
Consideration
For valuing contingent consideration, the market approach is rarely used due to the lack of an active
trading market. Even in the unusual case where a market exists for contingent consideration (such as
in the market for CVRs), the market often exhibits low trading volume, trades between related parties,
and/or perceived information asymmetries. The valuation specialist would need to consider these
factors along with other typical market approach reliability indicators to determine if the market
approach is useful, even in the rare case where market data on the value of contingent consideration is
available.
The cost approach is also typically not appropriate, because (1) there often is no obvious way to
estimate a replacement cost for a contingent consideration arrangement and (2) the cost approach does
not consider future expectations.
The Working Group has observed two income approach methods commonly used in practice to value
contingent consideration: SBM and OPM. Other methods also may exist or be developed in the future.
No single income approach method for valuing contingent consideration appears to be superior in all
respects and circumstances. Each of SBM and OPM has merits and challenges, these methods differ
in level of complexity, and there are trade-offs in selecting one method over the other.
However, the Working Group has concluded that there are contingent consideration types for which
each method is typically most appropriate. For the reasons articulated earlier in this section, the
Working Group recommends the following to select a method for valuing contingent consideration:
a) If the risk of the underlying metric is diversifiable, e.g., for achievement of a product
development milestone, choose SBM
b) If the payoff structure is linear (e.g., a fixed percentage of revenues or EBITDA with no
thresholds, caps, or tiers), choose SBM
c) If the risk of the underlying metric is non-diversifiable and the payoff structure has thresholds,
caps, tiers, or other nonlinearities, choose OPM
d) If the payoff structure is path dependent (e.g., a carry-forward feature, a catch-up provision or
a multi-year cap) or is based on multiple interdependent metrics, choose SBM or OPM as
recommended above, using a technique that can handle these complexities (such as Monte
Carlo simulation).
The Working Group does not recommend the use of SBM for nonlinear payoff structures involving a
metric with non-diversifiable risk. In this situation, the SBM discount rate would have to be adjusted
to account for the impact of the nonlinear payoff structure. However, the amount of the discount rate
adjustment cannot be easily intuited and the Working Group is not aware of any reasonable “rules of
thumb” for developing such adjustments. It is for this reason that OPM is recommended over SBM in
this situation.
Whether applied to the expected payoff cash flow (as in SBM) or to create a risk-neutral expected
payoff cash flow (as in OPM), the discount rate should incorporate a risk premium associated with
and appropriate to the underlying metric for the contingent consideration. The Required Metric Risk
Premium will often differ from the risk premium used to value the associated business, due to
differences in risk between the metric (such as revenue or EBITDA) and long-term free cash flows of
the business. For example, long-term free cash flows of the business are generally riskier than revenue,
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due to operational leverage. Thus, even for a linear payoff structure, the contingent consideration
discount rate will often differ from the WACC and from the transaction IRR.
Because the earnout is valued from the perspective of a market participant buying or selling the
standalone earnout post-transaction (with the relevant business under the new ownership of the actual
buyer), the financial projections developed for valuing an earnout should include buyer-specific
synergies unless the earnout agreement specifically excludes them from the definition of the metric.
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Section 6: Clawbacks
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There are cases where the parties to a transaction will structure the contingent consideration so that
the buyer may be entitled to a clawback (or refund) of a portion of the initial purchase consideration
from the seller. In these cases, the buyer has essentially taken out insurance that is payable by the seller
if the acquired business underperforms or to mitigate specific risks. Clawbacks are therefore
contingent assets to the buyer that reduce the fair value of the total purchase consideration.
Example: The sellers agree to pay the buyer one million if the EBITDA of the acquired
business falls below three million in the first year after the acquisition.
In general, the valuation considerations for clawbacks are the same as for earnouts. The valuation
specialist should consider the risk of and expectations for the underlying metric, the impact of the
clawback payoff structure on risk (especially if the structure is nonlinear), as well as any counterparty
credit risk.
6.1
Underlying Metrics for Clawbacks
Clawbacks tend to be structured to mitigate the risk of the acquired business underperforming over a
specified future period. As such, the underlying metrics or payment triggering events observed in
practice for clawbacks are generally the same as for earnouts, including:
• Financial or business metrics with systematic risk: revenue, EBITDA and net income, number
of units sold, etc.
• Nonfinancial milestone events (for a clawback, usually based on failure to achieve milestones
or negative events): regulatory approvals, resolution of legal disputes, execution of certain
commercial contracts or retention of customers, completion of certain software tasks or
construction projects, etc.
Therefore, the valuation considerations related to the underlying metrics or events for clawbacks are
typically the same as for earnouts. However, the impact on the valuation of the payoff structure of a
clawback can be significantly different from an earnout, as discussed in the following section.
6.2
The Impact of the Payoff Structure of Clawbacks on the Discount Rate
Unlike earnout payments, which are typically triggered as a result of outperformance or successfully
achieving certain milestones, clawback payments are often triggered as a result of underperformance,
failure to achieve certain milestones, or negative resolution of uncertainty. As a result, the value of a
clawback tends to increase as the anticipated performance of the underlying metric deteriorates. That
is, the value of a clawback is usually negatively correlated with the performance of the underlying
metric. Such a clawback can resemble a financial instrument with a negative beta, often resulting in a
negative discount rate applied to the expected future payments associated with the clawback.
Clawbacks resemble insurance contracts or put options. Just as the value of an insurance contract
increases as the likelihood of the downside event increases, so too does the value of a clawback
increase as the likelihood of poor performance or a negative triggering event increases.
A negative discount rate can arise naturally when valuing a clawback using an OPM, which often takes
the form of a put option (see the example in Section 9.11).
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6.3
Counterparty Credit Risk for Clawbacks
In general, clawbacks are typically an obligation of the seller to make future contingent payments to
the buyer. As such, the allowance for counterparty credit risk should be specific to the seller,
considering the seller’s credit risk and the expected timing of the payoff. This is different from a
typical earnout, where the buyer is typically the obligor and it is the buyer’s credit risk that is
considered.
In practice, since the sellers’ company no longer exists as a standalone entity post-transaction and the
obligors are often the individual former shareholders, the counterparty credit risk of the seller is often
mitigated through the use of an escrow account (or other credit risk mitigation mechanism as discussed
in Section 5.2.6). If present, the credit risk mitigation mechanism could cause the valuation specialist
to reduce or even remove the allowance for counterparty credit risk, depending on the extent of the
risk mitigation mechanism.
If the maximum possible clawback payment is not placed in escrow (and no other credit risk mitigation
mechanism is used), the credit risk of the seller in the typical scenarios in which the clawback will be
paid should be considered. Clawbacks are typically paid when the acquired business fails to perform
as expected. If such downside scenarios predominantly occur when the economy is notably poor or
are otherwise correlated with financial stress on the seller, the likelihood of seller default in such
downside scenarios may be larger than the overall credit risk associated with the seller.
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Section 7: Assessing the Reasonability of a Contingent Consideration
Valuation
The valuation of contingent consideration requires the estimation of a number of key inputs and
assumptions. It is important to maintain internal consistency among the assumptions used in the
contingent consideration valuation as well as to assess consistency with the assumptions for the
valuation of the overall business and/or related intangibles and with historical and market data. Finally,
it is important to consider the reasonableness of the total purchase consideration.
The remainder of this section addresses these considerations for assessing the reasonability of the
valuation of contingent consideration in more detail.
7.1
Consistency of the Earnout Metric Forecast in Single vs. Multi-scenario Valuation
Given the nature of contingent consideration, multiple scenarios will often be used to arrive at the
expected outcome for the earnout metric and also occasionally (depending on methodology) to
estimate the volatility for the metric and/or the expected payoff cash flow. In contrast, a business
valuation will often rely on only one scenario: typically, the deal model expected case scenario
(representing in principle the mean, i.e., the probability-weighted average of the possible scenarios for
future cash flows).
Using a different number of scenarios for the earnout computations versus the business valuation is
not, on its own, problematic. However, consistency between these two valuation techniques should be
evaluated. For instance, if the expected outcome for the earnout metric using multiple scenarios is
significantly different than the corresponding estimate in the single-scenario model used for the
valuation of the business, there could be a lack of consistency between the assumptions for the two
valuation models. Such an inconsistency, if significant, would imply that either the valuation of the
earnout or the valuation of the business is incorrect.
More generally, assuming the same measurement date and valuation basis, the expected value of the
projections for the earnout metric based on the probability distribution used in the earnout analysis
should equal the forecast of the same earnout metric implied by the expected cash flows used to value
the business or its intangibles (excluding any impact of buyer-specific synergies). If not, significant
distortions can arise.
For example, consider an earnout with a payoff equal to the excess of future EBITDA above 100,
where the EBITDA forecast used in the valuation of the business is 100. Assume there are no buyer-
specific synergies and no differences due an idiosyncratic definition of “EBITDA” for purposes of the
earnout. Recognizing that a deeper understanding of the distribution of EBITDA outcomes is required
to value the earnout, the valuation specialist gathers additional information, resulting in the probability
distribution for EBITDA to be used in the earnout analysis presented in Table 6.
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TABLE 6: Example Probability Distribution
Scenario Probability EBITDA Earnout payoff
(Max (EBITDA-100,0)
100
60
40
0
0
0
0
19.5
2.5%
15%
20%
25%
20%
15%
2.5%
200
160
140
100
80
70
60
110
1
2
3
4
5
6
7
Expected value
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The expected value (mean) of EBITDA for the earnout analysis is 110 (calculated as the probability-
weighted average across the scenarios).117 This value is different from the forecast of 100 used in the
business valuation.118 This mismatch between the EBITDA forecast for the business and the expected
value of the probability distribution for EBITDA assumed for the earnout can be problematic. It likely
means that using this distribution will cause the expected value of the earnout payoff (19.5 in this
example) to be overstated or that the valuation of the business is not using expected cash flows and
may therefore be understating value.
7.2
Consistency with Valuation of the Business, the Intangibles, and IPR&D
The assumptions made for the contingent consideration valuation should be consistent with those made
for valuation of the business and, when applicable, its intangible assets. The evaluation of consistency
should also allow for the different treatment of buyer-specific synergies for business valuation as
compared to contingent consideration valuation. Table 7 summarizes some of the key differences
between the valuation of a business and of an earnout; additional differences are described throughout
this guide. These key differences and other considerations are discussed in more detail in the remainder
of this section.
117 Specifically, the computation to arrive at the expected EBITDA is (200×2.5%) + (160×15%) + (140×20%) + (100×25%) +
(80×20%) + (70×15%) + (60×2.5%) = 110.
118 The assumed EBITDA probability distribution does have its most likely scenario equal to the forecast of 100. However, best practice
is for the valuation of the business to use expected cash flows. If expected cash flows are not used in the valuation of the business, an
adjustment—which is typically not easy to estimate—would have to be made to the discount rate for the valuation of the business to
account for any difference in risk between the expected cash flows and the most likely cash flows.
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TABLE 7: Comparison of Business Valuation (Income Approach) to Earnout Valuation
Business Valuation
Earnout Valuation
Projections
Level of detail Typically uses expected cash flows;
does not require assumptions about
the probability distribution around the
mean
Includes market participant synergies,
excludes buyer-specific synergies
Synergies
linear payoff
assumptions about
structure,
Unless
the
requires
probability distribution for future
outcomes for the earnout metric
Includes all synergies relevant to the
calculation of the payoff
Discount Rate
RFR
Long-term RFR
Counterparty
credit risk
Not relevant
Risk premium Risk premium for long-term free cash
flows (i.e., WACC or IRR less RFR)
Not relevant
Impact of
earnout
structure
RFR based on the time until the
earnout payment(s) are made
Typically, obligor’s credit spread for
subordinated debt in the scenarios in
which, and over the timeframe until,
the earnout payment(s) are made
RMRP for the earnout metric
For a metric with non-diversifiable
risk, nonlinear payoff structures
impact the effective discount rate
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Consistency with Business Projections: As discussed in Section 7.1, projections for the business in
principle should use the expected case cash flows (a single set of cash flows approximating the
probability-weighted average of the possible scenarios for the future). Typically, the same set of
projections should be considered as the starting point when valuing the contingent consideration.
However, earnout valuations typically require a probabilistic analysis, 119 including an assumption
about the distribution of future outcomes for the earnout metric. The methods described in Section 5
generally require (1) the use of multiple scenarios (for the SBM, e.g., for nonfinancial milestone
payments with predominantly diversifiable risk) and/or (2) the expected value for the metric and a
volatility around that expected value (for the OPM, assuming a lognormal distribution). Thus, for the
valuation of most earnouts, it is imperative to start with a full understanding of the probability
distribution for the metric outcome.
The projections used for the earnout valuation should be consistent with the projections used for the
business valuation, after allowing for any differences due to buyer-specific synergies or to the
definition of the earnout metric. A qualitative assessment of consistency with the projections for the
business should thus be performed. The example below illustrates how performing a consistency check
can identify a necessary revision to the assumptions.
119 The only situation in which an earnout valuation might not require understanding the probability distribution of the underlying metric
is when the earnout payoff has a linear structure, as explained in Section 4.4.
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Example: An asset management company was acquired. One year from the acquisition date,
the sellers are entitled to an earnout payment of one million if the client retention rate is 95%
or higher. Except in times of an economic downturn, it is uncommon for client retention rates
to be below 95%. Revenues are projected to grow by 2% over the next year, whereas typical
prior growth had been about 10% per year.
The valuation specialist planned to assume a probability of 90% that the 95% retention
threshold will be achieved, based on the historical retention rates. However, when management
is asked about the reasonability of the 90% assumption, the valuation specialist learns that the
lower projected growth in the next year is due to the anticipated loss of a key principal in the
firm and as a result, 20% of the clients are at high risk to depart post-acquisition.120 Therefore,
the 90% probability estimate for achieving the earnout payment is quite possibly inconsistent
with the assumptions used to forecast revenue for the company in the first year.
Consistency with Intangible(s) Projections: One may also need to assess the contingent consideration
assumptions relative to the assumptions for valuation of the intangible assets of the subject business.
For example, as part of valuing the intangible assets associated with an acquisition, a pharmaceutical
company may develop projections for a drug candidate under development. The projections used for
valuing an earnout contingent upon the success of that drug candidate should use consistent
assumptions for the probability of success and for performance estimates (revenues, units sold, timing
assumptions, etc.)
Consistency with Methodology for Valuing Assets and Liabilities of the Business: In some cases,
assets or liabilities of the business might involve nonlinear payoff structures. For example, a company
might pay (or receive payment of) royalty rates that are tiered at different rates based on future sales.
As another example, real estate leases might have contingencies based on the revenue of the lessee or
other nonlinear payoff structures. There is a potential for inconsistency if such assets or liabilities are
valued using a different methodology than is recommended in this Valuation Advisory for the
valuation of (related121) contingent consideration.
Market Participant Assumptions/Buyer-Specific Synergies: The forecast assumptions for the earnout
metric and subject business may vary due to differences in the assumptions related to synergies. In
terms of the fair value of the business, the value is estimated based on what market participants would
assume about the expected cash flows for the business. These assumptions are hypothetical and
exclude assumptions unique to one buyer, such as buyer-specific synergies.
However, as explained in Section 4.1, for that same transaction the market participant assumptions for
the earnout valuation can be different. Market participants evaluating the standalone earnout would
include in the calculation of the earnout cash flow any buyer-specific synergies that would affect the
payoff outcome for the earnout metric.
For this reason, buyer-specific synergies should be identified and, unless they are excluded from or
irrelevant to the definition of the earnout metric, included in the financial projections used for the
earnout valuation. Any such buyer-specific synergies should, however, be excluded from the valuation
of the business and its assets. The fact that buyer-specific synergies can impact the value of the
120 Note that because this issue also affects the value of customer relationships, it would typically be addressed in the process of valuing
those relationships.
121 For example, the contingent consideration valuation is related to the valuation of such assets and liabilities if the contingent
consideration metric is related (in our examples) to sales of the products that have the tiered royalty rates or to the lease revenues.
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transaction consideration but not the value of the business can also affect the check on the
reasonableness of the transaction IRR (see Section 7.5).
Discount Rates: The discount rate used for the contingent consideration valuation (either directly as
in an SBM or in the risk-neutral adjustment to the metric growth forecast in an OPM) should be
consistent with those used to value the business and its intangibles, after taking into account
differences such as those noted in Table 7. For example, if additional premiums (e.g., size, country, or
company-specific premiums) are added to the discount rate for the business valuation, appropriate
proportions of such additional premiums (with adjustments for differences in risk between the earnout
metric and the long-term free cash flows of the business, as discussed in Section 5.2.2) should be
considered for addition to the Required Metric Risk Premium.
Note, however, that the discount rate for the earnout will generally not be the same as the discount rate
for the business. The Required Metric Risk Premium will incorporate adjustments for differences in
risk between the contingent consideration metric and the long-term free cash flows of the business.
These differences in risk often include factors such as duration, volatility, correlation with the market,
and leverage. Further differences in risk are present if there are nonlinearities in the earnout payoff
structure associated with a financial metric (or other metric with non-diversifiable risk).
Volatility: Thought should also be given to maintaining consistency between the discount rates used
for the business and its intangible assets and the volatility assumed for the earnout metric. It is
commonly assumed that companies and assets with higher discount rates exhibit higher risks in their
earnings or cash flows, and therefore also would have higher volatilities. Empirical evidence supports
this assumption in some cases. For example, smaller companies (which on average have a higher
WACC than larger companies) also tend to experience higher volatility in net income, EBITDA, and
sales.122
Therefore, for example, it might be inconsistent to use the historical volatility of comparable
companies as a proxy for the volatility of growth in the earnout metric, if the subject business has a
higher discount rate than those comparables. See Section 5.2.4 for methods for adjusting the estimated
volatility in the growth rate for the earnout metric to account for common differences between acquired
businesses and public company comparables, such as size premiums or company-specific risk
premiums.
Further, consistency should be maintained between the estimated Required Metric Risk Premium for
the earnout metric and the estimated volatility in growth rate for the earnout metric. For example, a
RMRP of 20% and a metric growth rate volatility of 5% are likely not consistent.
Counterparty Credit Risk: When estimating counterparty credit risk for contingent consideration, one
should consider the credit risk specific to the obligor, not to a market participant. The valuation
specialist should consider the yield, if observable, on traded debt instruments for the obligor. When
assessing consistency, it is understood that differences may exist between the yield on these debt
obligations and the contingent consideration counterparty credit risk assumption due to differences in
duration and seniority of the obligations, correlation between financial stress and contingent
consideration payment scenarios, and potentially other significant differences between the debt and
the contingent consideration obligation.
122 See, for instance, Grabowski et al. (2017) Valuation Handbook U.S. Guide to Cost of Capital and Valuation Handbook
International Guide to Cost of Capital.
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Example: An acquisition occurs with potential annual earnout payments over a five-year
period. The acquirer has senior notes trading at a current market yield of 4.2% and subordinated
notes trading at a current market yield of 5.5%; both notes have a five-year remaining term.
The five-year risk-free rate as of the valuation date is 2.0%. The contingent consideration is
subordinated to the acquirer’s subordinated debt. The valuation specialist (incorrectly, as
described below) assumes a blended rate of 5.0% as a proxy for the cost of debt. After
subtracting the 2.0% risk-free rate, a counterparty credit risk adjustment of 3.0% is estimated.
This calculation ignores that the contingent consideration is a subordinated obligation to the
subordinated debt. Therefore, the estimated cost of debt should be higher than 5.5%. After
subtracting the 2.0% risk-free rate, the counterparty credit risk adjustment would have to be
larger than 3.5% to be consistent with the current market yield of the obligor’s existing debt.
7.3
Consistency with the Rationale for Including Contingent Consideration in the
Transaction
It is often the case that management or its mergers & acquisitions team, as a part of the acquisition
process, would have prepared either a deal model or management presentation outlining the buyer’s
expectations for the acquired company. Such documents, along with discussions with management,
can provide insights into the rationale for incorporating an earnout arrangement as part of the
transaction, for the choice of earnout metric, and for the chosen payoff structure.
As discussed in Section 1.3, the rationale for an earnout can include bridging the gap between the
buyer and seller perceptions of prospects for the business, incenting seller behavior post-transaction,
sharing of risks and rewards, and/or deferring a portion of the purchase consideration. The assumptions
related to risk and uncertainty associated with the earnout metric should be consistent with the
rationale for structuring the earnout arrangement. For example, if the earnout has been structured
primarily to share a significant risk related to revenues in year one, it could potentially be inconsistent
for the volatility of revenues in year one to be low. Indeed, in such a situation, one might expect the
acquiree’s volatility of revenues in year one to be higher than the volatility observed for comparable
public companies. On the other hand, if the primary rationale is for the earnout to serve as a form of
seller financing of the transaction (deferring payment for a year), then the volatility of revenues for
comparable companies might be an appropriate assumption for the acquiree’s business.
7.4
Consistency with Historical and Market Data
In assessing the riskiness of the projected cash flows and scenario probabilities for valuing contingent
consideration, historical and market data should be considered. From a market participant point of
view, relevant factors to consider might include, for example:
• Historical financial performance of the subject business and comparable companies
• The reasonableness of the acquired company’s projected growth and profitability expectations,
and the risks of achieving those projections, in light of historical company and market data
• The risks of achieving anticipated technical milestones and/or acquisition synergies, as
benchmarked against historical experience for the subject business, the acquirer, and
comparable companies
• Historical subject business experience with volatility of actual results versus business plan
forecasts
• The discount rates and volatilities of comparable companies.
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Example: The projections for the acquired business contain 50% revenue growth for the next
three years and a profit margin of 30%. The company’s historical revenue growth rates were
between 5% and 10% per year with a profit margin of about 10%. The acquisition rationale
includes offering the acquired company’s products to the buyer’s customer base, which could
result in significant revenue increases and higher profit margins due to increased scale. The
buyer has achieved similar revenue growth rates for similar past transactions. However, the
buyer’s and other comparable companies’ profit margins are in a relatively tight range around
15%.
In this case, given the acquirer’s historical success with previous deals, the projected revenue
growth rates could be reasonable. However, the projected margins are significantly above all
the benchmarks and, therefore, this assumption would need to be evaluated further.123
7.5
Reasonableness of the Total Purchase Consideration and IRR
In the context of a business combination, contingent consideration is required to be valued initially
pursuant to ASC Topic 805 or IFRS 3R, Business Combinations. According to ASC 805-30-25-5 and
IFRS 3:39, “The acquirer shall recognize the acquisition-date fair value of contingent consideration as
part of the consideration transferred in exchange for the acquiree.”
One way of assessing the reasonableness of the contingent consideration value is to evaluate the total
purchase consideration inclusive of the value of the contingent consideration, relative to what a market
participant would be willing to pay for the business. This fair value estimate can be arrived at using
the measurement framework and guidance of ASC Topic 820 or IFRS 13, Fair Value Measurement.
For example, the market approach could be used to compare the implied multiple from the transaction
to those of comparable public companies or comparable acquired companies.
Another common method used to assess the reasonableness of the total consideration is an IRR
analysis for the transaction. IRR analysis is discussed in the Appraisal Practices Board’s Valuation
Advisory #1: Identification of Contributory Assets and Calculation of Economic Rents (the
“Contributory Asset Guide”). The Contributory Asset Guide describes an IRR analysis as follows:
“the IRR in a transaction is the discount rate at which the present value of the prospective financial
information (PFI) of the acquired entity (adjusted if necessary for market participant assumptions) is
equal to the purchase price … because of potential adjustments to the purchase price and to the PFI,
the valuation specialist’s IRR may not be consistent with management’s internal assumptions.” If the
IRR doesn’t seem reasonable compared to other marketplace transactions, the valuation specialist
would typically review the assumptions leading to that IRR—including those underlying the
contingent consideration valuation, the expected case financial projections, etc.—and would also
consider whether there might be a bargain purchase or an overpayment situation.
The value of the contingent consideration will affect the overall purchase price (typically increasing
it, for an earnout). As a result, if there is an earnout, the IRR would need to be lowered in order for the
higher purchase price to equal the sum of the present value of the projected cash flows. To the extent
that the IRR was relied upon to assist in the estimation of a company-specific risk premium for the
transaction, this lowering of the IRR could also result in a lower discount rate for the earnout metric.124
123 This issue should also be identified when valuing the business and its intangibles.
124 In rare cases, where the inclusion of buyer-specific synergies in the earnout significantly increases the value of the total purchase
consideration to a level that is inconsistent with other marketplace transactions, the valuation specialist should identify the reasons and
be able to reasonably explain why the acquirer is willing to pay for its own unique synergies. An IRR that doesn’t seem reasonable
compared to other marketplace transactions may indicate that the expected achievement level for the buyer-specific synergies included
in the earnout valuation might be overly optimistic.
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The interaction between the value of the earnout and the IRR thus creates a circular relationship, i.e.,
adding the fair value of the earnout to the purchase price lowers the IRR and therefore lowers the
estimated company-specific risk premium, which lowers the earnout discount rate, raises the fair value
for the earnout, and further increases the purchase price. The higher purchase price, in turn, would
result in the valuation specialist needing to repeat the IRR analysis. While this circular relationship
causes some added level of complexity (and often, the need to iteratively recalculate the value of the
earnout and the IRR until the analysis converges on an estimate of the company-specific risk
premium), the Working Group believes that this relationship must be, and can be, addressed properly
and in a manner where the IRR is consistent with the earnout valuation. The need to iteratively
recalculate the value of the earnout may also impact other parts of the valuation analysis, such as the
weighted average return on assets (or “WARA,” also discussed in the Contributory Asset Guide) or
the estimated return on certain intangible assets (e.g., IPR&D).
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Section 8: Updating Contingent Consideration Valuation
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Typically, an earnout will result in the acquirer recognizing a liability on its balance sheet, measured
at fair value. Under U.S. GAAP or IFRS, for contingent consideration classified as an asset or a
liability, at each subsequent reporting date prior to the contingent consideration being resolved, the
fair value of the asset or liability is remeasured. However, if the contingent consideration is classified
as equity, the carrying value (i.e., the acquisition date fair value) of the contingent consideration is not
remeasured subsequent to the acquisition date.
While the process of updating the fair value of an earnout at a subsequent reporting period is similar
to the process used in the initial measurement, there are important nuances to consider.
8.1
Valuation Methodology for Updating the Fair Value of Contingent Consideration
This Valuation Advisory outlines various methods that might be used in estimating the fair value of
an earnout. At the initial measurement date, the valuation method or methods anticipated to provide
the most reliable estimate of fair value and that are most appropriate given the structure of the earnout
would be utilized to estimate the fair value of the earnout. The Working Group believes that, while
there may be exceptions, the methodology used in updating the fair value of an earnout should
generally be consistent with the methodology used in the initial measurement. An example of such an
exception is when enough uncertainty has been resolved that the structure of the earnout is no longer
relevant to the choice of methodology (e.g., the amount of the payment is known with near certainty,
the structure has become linear because the only nonlinearity—a cap—is now known to not be active,
or there is only one period left so the carryforward is known and the earnout is no longer path
dependent.) Judgment should be applied in determining whether a change in methodology is
appropriate at subsequent dates based on the facts and circumstances.
8.2
Updating the Valuation Inputs
As described in previous sections, the valuation of an earnout at initial measurement may require the
estimation of multiple inputs based on the facts and circumstances existing (known or knowable) on
the transaction date, including certain assumptions and expectations regarding the possible payoff of
the contingent consideration arrangement. At subsequent measurement dates, the fair value of the
earnout liability should be measured based on the updated information available as of each respective
date. To the extent the facts and circumstances have changed and additional relevant information is
available, the inputs used in the earnout valuation methodology should be updated.
While there might be exceptions (for example due to improvements in methodology or where certain
information sources are no longer available or relevant), consistency should generally be maintained
in the methodology for estimating inputs. A similarly rigorous process to estimate the expected
outcome for the earnout metric, volatility, and discount rate should be utilized for the subsequent
valuations as was used for the initial valuation. Moreover, the updated inputs should be consistent with
the original inputs, after taking into account any relevant new information, uncertainty resolution,
business evolution, and the passage of time.
Included below are some of the valuation issues that may need to be considered for valuations
performed subsequent to the initial measurement date.
2820
8.2.1 Actual Results Related to the Earnout Metric
2821
2822
Actual results regarding the earnout metric(s) may be available at subsequent measurement dates. For
instance, if the earnout payment is contingent on financial performance, actual results may now be
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available for a portion of the earnout period, even if an earnout payment is not yet contractually
required. The valuation model should take these actual results into account. The actual results may be
such that some of the uncertainty regarding the earnout payoff is resolved.
Example: An earnout is based on the cumulative revenue over the first two years post-close.
When updating the earnout value at the end of year one, the actual year one revenue would
now be known; it is no longer subject to systematic risk or uncertainty. As such, there is no
longer a need to estimate year one revenue and the year one revenue in the earnout valuation
model would be updated based on the actual revenue.
2831
8.2.2 Updated Forecast for the Earnout Metric
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In addition to the possibility that actual results may have resolved some of the uncertainty regarding
the earnout metric, market participant assumptions regarding the expectations for the unresolved
portion of the earnout may also have changed, and these changes in expectations should be reflected
in the updated valuation.
Example: Continuing with the prior example, assume that based on the positive results for year
one revenue and higher demand anticipated within the industry, the company expects revenue
to be 10% higher for year two than was anticipated at the initial earnout measurement date.
This updated expectation for year two revenue would be incorporated into the valuation model
along with the actual results for year one.
From a consistency perspective, it is advantageous if the updated expected case for the earnout metric
is forecast in a similar manner as for the original valuation. This can be challenging if the company
does not have as robust a set of projection scenarios from which to compute the expected case as of a
subsequent period as at the initial transaction date. Nevertheless, it is important to ensure that the
forecast used for the contingent consideration valuation update is still estimated based on the expected
case at the time of the update.
Further, the updated forecast should be consistent with the original forecast, in light of any resolution
in the initial uncertainty and any evolution in expectations for the business. If the relevant portion of
the business has outperformed, one would typically expect the forecast to have increased, and if it has
underperformed, one would typically expect the forecast to have declined. For example, continued
optimism with respect to future projections when the initial results have fallen far short of the
projections at the time of the deal close might warrant extra scrutiny. More generally, if a trend is
observed in actual results to date, the valuation specialist should consider whether the updated
projections should be consistent with a continuation of that trend.
2855
8.2.3 Updated Discount Rate and Volatility for the Earnout Metric
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When updating the earnout metric discount rate (or Required Metric Risk Premium), the estimation
process should take into account changes related to the risk of the earnout metric, updated market-
based inputs (e.g., risk-free rates, estimated betas and other inputs into the estimation of the RMRP)
and changes as a result of the passage of time. For instance, if the transaction IRR was used as a
starting point for estimating the RMRP at the initial transaction date, then facts and circumstances
should be considered to determine whether the IRR is still a relevant starting point at the subsequent
measurement date. Even if so, if adjustments to the IRR were made, these adjustments would need to
be reconsidered and updated based on information available as of the subsequent measurement date.
For example, if the IRR was adjusted for a shorter timeframe based on the relative U.S. Treasury yields
at the initial measurement date, a similar adjustment would need to be made based on market risk-free
rates at the subsequent measurement date.
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In addition to updating the market-based components of the earnout metric discount rate, if a company-
specific risk premium was included as a component of the RMRP at initial measurement, judgment
should be applied in determining whether market participants would perceive the same degree of
company-specific risk at the subsequent measurement date. The company-specific risk premium
should be adjusted accordingly. For example, if a significant portion of the uncertainty about the
success of post-transaction integration activities has been resolved at the subsequent measurement date
and this uncertainty was a key driver of the company-specific risk at initial measurement, then the
discount rate used in updating the fair value of the contingent consideration should reflect the lower
risk.
Similar to the discount rate, if an option pricing method is utilized, volatility assumptions will need to
be updated for the portion of the earnout period that remains. The volatility estimate could be impacted
by updated market conditions, the shorter length of time remaining in the earnout period, and actual
results, among other factors.
Even if the actual results are not available for the entire earnout period, there may be updated
information that significantly changes the assessment of risk for the remaining portion of the earnout
period. For instance, continuing with the prior example, if year one revenue is now known and the
company has backlog for year two revenue that will result in cumulative year one and year two revenue
being sufficient to ensure at least 75% of the maximum earnout payment, there may be much less risk
and also less volatility assumed in the update valuation than at the initial measurement.
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8.2.4 Updated Counterparty Credit Risk
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Counterparty credit risk should be updated based on an updated assessment of the risk associated with
the obligor being unable to make the contingent consideration payments if and when they fall due,
taking into account the updated forecasts, the current market conditions, and the financial position of
the obligor as of the subsequent valuation date.
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Section 9: Examples of Valuation of Common Contingent Consideration
Payoff Structures
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The following is a series of examples that illustrates the estimation of the fair value of contingent
consideration with payoff structures commonly found in practice. The input assumptions in these
examples are presumed to be known. Also, for all examples with financial metrics we have assumed
(1) that the financial metrics follow a GBM and (2) the mid-period convention, i.e., that the financial
metric is earned at the midpoint of the period to which it applies. All discount rates are assumed to be
annual, continuously compounded. In addition, for all examples we have assumed zero correlation
between the scenarios in which contingent consideration payments are due and the scenarios in which
the acquirer is unable to fulfill its contingent consideration payment obligations.
9.1
Example: Linear Payoff Structure (EBITDA)
2900
Earnout Payoff Structure
2901
2902
Company A will be required to pay 30% of the acquiree’s EBITDA earned over the subsequent
one-year period. The payment is due three months after the end of the year.
2903
Assumptions
2904
2905
2906
2907
2908
Forecast annual EBITDA:
Discount rate applicable to future EBITDA:
Risk-free rate over payment period:
Required Metric Risk Premium:
Credit spread of Company A:
2,000
10%
0.5%
9.5% {= 10% − 0.5%}
3%
2909
Valuation Methodology
2910
2911
2912
2913
2914
2915
2916
2917
2918
2919
Since the earnout is a linear function of
EBITDA, only the expected case EBITDA is
needed to estimate the expected future cash flow
of the earnout. Also, a risk-neutral framework is
not needed to incorporate the impact of the
structure on the discount rate. For illustration
purposes, and to compare with more complex
structures, we will perform the analysis in both
an SBM (using the expected case) and an OPM
framework.
2920
Calculations Using SBM
2921
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[1] Expected future value of earnout payment:
[2] Discount factor for risk of EBITDA (mid-period)
[3] Discount factor for time from mid-period to payment:
[4] Discount factor for credit risk*:
Value of earnout:
600.00 { = 2,000 × 30% }
0.95123 { = exp(-10.0% × 0.5) }
0.99626 { = exp(-0.5% × (1.25 - 0.5)) }
0.96319 { = exp(-3.0% × 1.25) }
547.67 { = [1] × [2] × [3] × [4]}
Calculations Using OPM
[5] Expected present value of EBITDA:
[6] Expected future value of EBITDA (risk-neutral):
[7] Equivalent RMRP-adjusted forecast:
[8] Expected future earnout cash flow (risk-neutral):
1,902.46 { = 2,000 × exp(-10% × 0.5) }
1,907.22 { = [5] × exp(0.5% × 0.5) }
1,907.22 { = 2,000 × exp(-9.5% × 0.5) }
572.17 { = [6] × 30% }
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[9] Discount factor for credit risk and time value*:
Value of earnout:
0.9572 { = exp(-(3.0%+0.5%) × 1.25) }
547.67
Expected future value of earnout payment:
Implied discount rate, excluding credit risk
600.00 { = [1]}
10.0% { = loge([1]/[8])/(1 – 0.5) + 0.5% }
*Credit risk and time value of money from the valuation date to the payment date.
9.2
Example: Linear Payoff Structure (Revenue)
This example is the same as Example 9.1, except the earnout is based on the first year of revenue
rather than EBITDA. For this reason, the Required Metric Risk Premium differs between these two
examples.
2940
Earnout Payoff Structure
2941
2942
Company A will be required to pay 30% of the acquiree’s revenue earned over the subsequent
one-year period. The payment is due three months after the end of the year.
2943
Assumptions
2944
2945
2946
2947
2948
Forecast annual revenue:
Discount rate applicable to future revenue:
Risk-free rate over payment period:
Required Metric Risk Premium:
Credit spread of Company A:
2,000
5%
0.5%
4.5% {= 5% − 0.5%}
3%
2949
Valuation Methodology
2950
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2973
Since the earnout is a linear function of revenue,
only the expected case revenue is needed to
estimate the expected future cash flow of the
earnout. Also, a risk-neutral framework is not
needed to incorporate the impact of the structure
on the discount rate. For illustration purposes,
and to compare with more complex structures,
we will perform the analysis in both an SBM
the expected case) and an OPM
(using
framework.
Calculations Using SBM
[1] Expected future value of earnout payment:
[2] Discount factor for risk of revenue (mid-period)
[3] Discount factor for time from mid-period to payment:
[4] Discount factor for credit risk*:
Value of earnout:
600.00 { = 2,000 × 30% }
0.97531 { = exp(-5.0% × 0.5) }
0.99626 { = exp(-0.5% × (1.25 - 0.5)) }
0.96319 { = exp(-3.0% × 1.25) }
561.54 { = [1] × [2] × [3] × [4]}
Calculations Using OPM
[5] Expected present value of revenue:
[6] Expected future value of revenue (risk-neutral):
[7] Equivalent RMRP-adjusted forecast:
[8] Expected future earnout cash flow (risk-neutral):
[9] Discount factor for credit risk and time value*:
Value of earnout:
1,950.62 { = 2,000 × exp(-5.0% × 0.5) }
1,955.50 { = [5] × exp(0.5% × 0.5) }
1,955.50 { = 2,000 × exp(-4.5% × 0.5) }
586.65 { = [6] × 30% }
0.9572 { = exp(-(3.0%+0.5%) × 1.25) }
561.54
Expected future value of earnout payment:
600.00
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Implied discount rate, excluding credit risk:
5.0%
{ = loge([1]/[8])/(1 – 0.5)+0.5% }
*Credit risk and time value of money from the valuation date to the payment date.
9.3
Example: Technical Milestone (Diversifiable Binary) Structure
2977
Earnout Payoff Structure
2978
2979
2980
2981
Company A will be required to pay 100 upon the achievement of a technical (nonfinancial)
milestone that represents a diversifiable risk. The success or failure of achievement of the
milestone will be determined in one year. The payment is due three months after the milestone is
achieved.
2982
Assumptions
2983
2984
2985
Probability of success/failure:
Risk-free rate over payment period:
Credit spread of Company A:
60% / 40%
0.5%
3%
2986
Valuation Methodology
2987
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Since the earnout is a nonlinear function of the
outcome, a probabilistic framework is needed to
estimate the expected future cash flow of the
earnout. A risk-neutral framework, however, is
not needed since the risk of the underlying
outcome is diversifiable. Since the risk of the
underlying outcome can be fully diversified, the
discount rate need only account for time value
of money and counterparty credit risk (i.e., the
cost of debt of Company A specific to the term
and seniority of the earnout obligation).
2998
Calculations Using SBM
2999
3000
3001
3002
3003
3004
3005
3006
[1] Expected future value of earnout payment:
[2] Discount factor for systematic risk:
[3] Discount factor for time to payment:
[4] Discount factor for credit risk:
Value of earnout:
60.00
1.0
{ = 100 × 60% }
{ because beta = 0 }
0.99377 { = exp(-0.5% × 1.25) }
0.96319 { = exp(-3.0% × 1.25) }
{ = [1] × [2] × [3] × [4] }
57.43
Expected future value of earnout payment:
Implied discount rate, excluding credit risk:
60.00
0.5%
{ = loge([2])/(1 – 0.5) + 0.5% }
9.4
Example: Financial Milestone (Systematic Binary) Structure
3007
Earnout Payoff Structure
3008
3009
Company A will be required to pay 100 if the acquiree’s annual EBITDA exceeds 2,000 over the
subsequent one-year period. The payment is due three months after the end of the year.
3010
Assumptions
3011
3012
3013
3014
Forecast annual EBITDA:
2,000
Expected volatility of future annual EBITDA: 50%
10%
Discount rate applicable to future EBITDA:
0.5%
Risk-free rate to payment period:
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3016
Required Metric Risk Premium:
Credit spread of Company A:
9.5% {= 10% − 0.5%}
3%
3017
Valuation Methodology
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Since the earnout is a nonlinear function of
EBITDA, a probabilistic framework is needed
to estimate the expected future cash flow of the
earnout. The valuation is performed in a risk-
neutral framework to incorporate the impact of
the nonlinear payoff structure on the discount
rate. The earnout payoff structure can be
replicated as a long digital/binary call option
with strike = 2,000 in an OPM framework.
Black-Scholes-Merton Digital/Binary Call Option
Formula
−rT
d2 = (log𝑀𝑀(S0 K⁄ ) + (r − 0.5σ
Where
Digital/Binary Call Option = P × N(d2) × e
N(.): standard normal cumulative distribution function
P: payment upon the underlying reaching the strike price
T: term of the option
r: risk-free rate commensurate with term T
) × T)/σ√T
2
S0: present value of the underlying
K: strike price
σ: volatility of the underlying
loge(.): natural logarithm function
3035
Calculations
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3049
[1] Expected present value of EBITDA:
[2] Expected future value of EBITDA (risk-neutral):
[3] Equivalent RMRP-adjusted forecast:
[4] Expected future earnout cash flow (risk-neutral):
[5] Discount factor for credit risk and time value**:
Value of earnout:
1,902.46 { = 2,000 × exp(-10% × 0.5) }
1,907.22 { = [1] × exp(0.5% × 0.5) }
1,907.22 { = 2,000 × exp(-9.5% × 0.5) }
37.785 {*}
0.9572 { = exp(-(3.0%+0.5%) × 1.25) }
36.17
[6] Expected future value of earnout payment:
Implied annual discount rate, excluding credit risk:
42.984 {***}
26.28% { = loge([6]/[4])/(1 – 0.5) + 0.5% }
*Digital Call × exp(0.5% × 0.5). Inputs to Black-Scholes-Merton Digital Call formula: S0 = [1]; K = 2,000; r = 0.5%; σ = 50%;
T = 0.5; P = 100.
**Credit risk and time value of money from the valuation date to the payment date.
***Digital Call × exp(10% × 0.5). Inputs to Digital Call formula: S0 = [1]; K = 2,000; r = 10%; σ = 50%; T = 0.5; P = 100.
9.5
Example: Threshold (Call Option) Structure
3050
Earnout Payoff Structure
3051
3052
3053
Company A will be required to pay 30% of the excess of the acquiree’s annual EBITDA above
2,000 over the subsequent one-year period. The payment is due three months after the end of the
year.
3054
Assumptions
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2,000
Forecast annual EBITDA:
Expected volatility of future annual EBITDA: 50%
10%
Discount rate applicable to future EBITDA:
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Risk-free rate to payment period:
Required Metric Risk Premium:
Credit spread of Company A:
0.5%
9.5% {= 10% − 0.5%}
3%
3061
Valuation Methodology
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3069
3070
Since the earnout is a nonlinear function of
EBITDA, a probabilistic framework is needed
to estimate the expected future cash flow of the
earnout. The valuation is performed in a risk-
neutral framework to incorporate the impact of
the nonlinear payoff structure on the discount
rate. The earnout payoff structure can be
replicated as a call option with strike = 2,000 in
an OPM framework.
3071
Black-Scholes-Merton Call Option Formula
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3073
3074
3075
3076
3077
3078
3079
3080
3081
3082
3083
3084
3085
3086
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3091
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3093
−rT
d1 = (log𝑀𝑀(S0 K⁄ ) + (r + 0.5σ
Where
Call Option = S0 × N(d1) − K × N(d2) × e
N(.): standard normal cumulative distribution function
K: strike price
σ: volatility of the underlying
loge(.): natural logarithm function
2
2
) × T)/σ√T 𝑎𝑎𝑎𝑎𝑎𝑎 d2 = (ln(S0 K⁄ ) + (r − 0.5σ
S0: present value of the underlying
T: term of the option
r: T-year risk-free rate
) × T)/σ√T
Calculations
[1] Expected present value of EBITDA:
[2] Expected future value of EBITDA (risk-neutral):
[3] Equivalent RMRP-adjusted forecast:
[4] Expected future earnout cash flow (risk-neutral):
[5] Discount factor for credit risk and time value**:
Value of earnout:
[6] Expected future value of earnout payment:
Implied discount rate, excluding credit risk:
1,902.46 { = 2,000 × exp(-10% × 0.5) }
1,907.22 { = [1] × exp(0.5% × 0.5) }
1,907.22 { = 2,000 × exp(-9.5% × 0.5) }
69.053 {*}
0.9572 { = exp(-(3.0%+0.5%) × 1.25) }
66.10
84.190 {***}
40.14% { = loge([6]/[4])/(1 – 0.5) + 0.5% }
*30% × Call Option × exp(0.5% × 0.5). Inputs to Black-Scholes-Merton Call option formula: S0 = [1]; Strike = 2,000; r = 0.5%;
σ = 50%; Term = 0.5.
**Credit risk and time value of money from the valuation date to the payment date.
***30% × Call Option × exp(10% × 0.5). Inputs to Black-Scholes-Merton Call option formula: S0 = [1]; Strike = 2,000; r = 10%;
σ = 50%; Term = 0.5.
9.6
Example: Percentage of Total above a Threshold (Asset-or-Nothing) Structure
3094
Earnout Payoff Structure
3095
3096
3097
Company A will be required to pay 30% of the acquiree’s annual EBITDA if the annual EBITDA
exceeds 2,000 over the subsequent one-year period. The payment is due three months after the end
of the year.
3098
Assumptions
3099
3100
2,000
Forecast annual EBITDA:
Expected volatility of future annual EBITDA: 50%
VFR Valuation Advisory #4 - Valuation of Contingent Consideration
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98
3101
3102
3103
3104
Discount rate applicable to future EBITDA:
Risk-free rate to payment period:
Required Metric Risk Premium:
Credit spread of Company A:
10%
0.5%
9.5% {= 10% − 0.5%}
3%
3105
Valuation Methodology
3106
3107
3108
3109
3110
3111
3112
3113
3114
3115
Since the earnout is a nonlinear function of
EBITDA, a probabilistic framework is needed
to estimate the expected future cash flow of the
earnout. The valuation is performed in a risk-
neutral framework to incorporate the impact of
the nonlinear payoff structure on the discount
rate. The earnout payoff structure can be
replicated as a digital call option with strike =
2,000 plus a call option with strike = 2,000 in an
OPM framework.
3116
Calculations
3117
3118
3119
3120
3121
3122
3123
3124
3125
3126
3127
3128
3129
3130
3131
[1] Expected present value of EBITDA:
[2] Expected future value of EBITDA (risk-neutral):
[3] Equivalent RMRP-adjusted forecast:
[4] Expected future earnout cash flow (risk-neutral):
[5] Discount factor for credit risk and time value**:
Value of earnout:
1,902.46
1,907.22
1,907.22
295.76
0.9572
283.10
{ = 2,000 × exp(-10% × 0.5) }
{ = [1] × exp(0.5% × 0.5) }
{ = 2,000 × exp(-9.5% × 0.5) }
{*}
{ = exp(-(3.0%+0.5%) × 1.25) }
[6] Expected future value of earnout payment:
Implied discount rate, excluding credit risk:
342.09
29.60%
{***}
{ = loge([6]/[4])/(1 – 0.5) + 0.5% }
*(Digital Call Option + 30% × Call Option) × exp(0.5% × 0.5). Inputs to Black-Scholes-Merton Option formulae: S0 = [1];
Strike = 2,000; r = 0.5%; σ = 50%; Term = 0.5; Digital payment = 2,000×30% = 600.
**Credit risk and time value of money from the valuation date to the payment date.
***(Digital Call Option + 30% × Call Option) × exp(10% × 0.5). Inputs to Black-Scholes-Merton Option formulae: S0 = [1];
Strike = 2,000; r = 10%; σ = 50%; Term = 0.5; Digital payment = 2,000×30% = 600.
9.7
Example: Threshold and Cap (Capped Call) Structure
3132
Earnout Payoff Structure
3133
3134
3135
Company A will be required to pay 30% of the excess of the acquiree’s annual EBITDA above
2,000 over the subsequent one-year period with a payment cap of 300. The payment is due three
months after the end of the year.
3136
Assumptions
3137
3138
3139
3140
3141
3142
Forecast annual EBITDA:
2,000
Expected volatility of future annual EBITDA: 50%
10%
Discount rate applicable to future EBITDA:
0.5%
Risk-free rate to payment period:
9.5% {= 10% − 0.5%}
Required Metric Risk Premium:
3%
Credit spread of Company A:
VFR Valuation Advisory #4 - Valuation of Contingent Consideration
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99
3143
Valuation Methodology
3144
3145
3146
3147
3148
3149
3150
3151
3152
3153
3154
3155
3156
3157
3158
3159
3160
3161
3162
3163
3164
3165
3166
3167
3168
3169
Since the earnout is a nonlinear function of
EBITDA, a probabilistic framework is needed
to estimate the expected future cash flow of the
earnout. The valuation is performed in a risk-
neutral framework to incorporate the impact of
the nonlinear payoff structure on the discount
rate. The earnout payoff structure can be
replicated as a long call option with strike =
2,000 minus a short call option with strike =
3,000 in an OPM framework.
Calculations
[1] Expected present value of EBITDA:
[2] Expected future value of EBITDA (risk-neutral):
[3] Equivalent RMRP-adjusted forecast:
[4] Expected future earnout cash flow (risk-neutral):
[5] Discount factor for credit risk and time value**:
Value of earnout:
1,902.46
1,907.22
1,907.22
57.16
0.9572
54.71
{ = 2,000 × exp(-10% × 0.5) }
{ = [1] × exp(0.5% × 0.5) }
{ = 2,000 × exp(-9.5% × 0.5) }
{*}
{ = exp(-(3.0%+0.5%) × 1.25) }
[6] Expected future value of earnout payment:
Implied discount rate, excluding credit risk:
68.12
35.58% { = loge([6]/[4])/(1 – 0.5) + 0.5% }
{***}
*(30% × Call Option1 ‒ 30% × Call Option2) × exp(0.5% × 0.5). Inputs to Black-Scholes-Merton Call Option formulae: S0 = [1];
Strike1 = 2,000; Strike2 = 3,000; r = 0.5%; σ = 50%; T = 0.5.
**Credit risk and time value of money from the valuation date to the payment date.
***(30% × Call Option1 ‒ 30% × Call Option2) × exp(10% × 0.5). Inputs to Black-Scholes-Merton Call Option formulae: S0 = [1];
Strike1 = 2,000; Strike2 = 3,000; r = 10%; σ = 50%; T = 0.5.
9.8
Example: Tiered Payoff Structure
3170
Earnout Payoff Structure
3171
3172
3173
Company A will be required to pay 30% of the excess of the acquiree’s annual EBITDA above
2,000, plus 10% of the excess annual EBITDA above 2,400 over the subsequent one-year period
with a payment cap of 200. The payment is due three months after the end of the year.
3174
Assumptions
3175
3176
3177
3178
3179
3180
2,000
Forecast annual EBITDA:
Expected volatility of future annual EBITDA: 50%
10%
Discount rate applicable to future EBITDA:
0.5%
Risk-free rate to payment period:
9.5% {= 10% − 0.5%}
Required Metric Risk Premium:
3%
Credit spread of Company A:
VFR Valuation Advisory #4 - Valuation of Contingent Consideration
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3181
Valuation Methodology
3182
3183
3184
3185
3186
3187
3188
3189
3190
3191
3192
3193
3194
3195
3196
3197
3198
3199
3200
3201
3202
3203
3204
3205
3206
3207
3208
Since the earnout is a nonlinear function of
EBITDA, a probabilistic framework is needed
to estimate the expected future cash flow of the
earnout. The valuation is performed in a risk-
neutral framework to incorporate the impact of
the nonlinear payoff structure on the discount
rate. The earnout payoff structure can be
replicated as a long call option with strike =
2,000, minus a short call option with strike =
2,400 and minus a short call option with strike
= 3,200 in an OPM framework.
Calculations
[1] Expected present value of EBITDA:
[2] Expected future value of EBITDA (risk-neutral):
[3] Equivalent RMRP-adjusted forecast:
[4] Expected future earnout cash flow (risk-neutral):
[5] Discount factor for credit risk and time value**:
Value of earnout:
1,902.46
1,907.22
1,907.22
43.003
0.9572
41.16
{ = 2,000 × exp(-10% × 0.5) }
{ = [1] × exp(0.5% × 0.5) }
{ = 2,000 × exp(-9.5% × 0.5) }
{*}
{ = exp(-(3.0%+0.5%) × 1.25) }
[6] Expected future value of earnout payment:
Implied discount rate, excluding credit risk:
50.746
33.61%
{***}
{ = loge([6]/[4])/(1 – 0.5) + 0.5% }
*(30% × Call Option1 ‒ 20% × Call Option2 ‒ 10% × Call Option3) × exp(0.5% × 0.5). Inputs to Black-Scholes-Merton Call Option
formulae: S0 = [1]; Strike1 = 2,000; Strike2 = 2,400; Strike3 = 3,200; r = 0.5%; σ = 50%; T = 0.5.
**Credit risk and time value of money from the valuation date to the payment date.
***(30% × Call Option1 ‒ 20% × Call Option2 ‒ 10% × Call Option3) × exp(10% × 0.5). Inputs to Black-Scholes-Merton Call
Option formulae: S0 = [1]; Strike1 = 2,000; Strike2 = 2,400; Strike3 = 3,200; r = 10%; σ = 50%; T = 0.5.
9.9
Example: Multi-year, Not Path Dependent (Series of Capped Calls)
3209
Earnout Payoff Structure
3210
3211
3212
3213
Company A will be required to pay 30% of the excess of the acquiree’s annual EBITDA above
2,000 with a payment cap of 300 for the first year, and 30% of the excess of the Target’s annual
EBITDA above 2,400 with a payment cap of 300 for the second year. The payments are due three
months after the end of each earnout period.
3214
Assumptions
3215
3216
3217
3218
3219
3220
3221
1st year annual EBITDA forecast:
2,000
2nd year annual EBITDA forecast:
2,400
Expected volatility of future annual EBITDA: 50%
10%
Discount rate applicable to future EBITDA:
0.5%
Risk-free rate to payment period:
9.5% {= 10% − 0.5%}
Required Metric Risk Premium:
3%
Credit spread of Company A:
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3222
Valuation Methodology
3223
3224
3225
3226
Since the earnout is a nonlinear function of EBITDA, a probabilistic framework is needed to
estimate the expected future cash flow of the earnout. The valuation is performed in a risk-neutral
framework to incorporate the impact of the nonlinear payoff structure on the discount rate. The
earnout payoff structure can be replicated as a series of long and short call options in an OPM
3227
3228
3229
3230
3231
3232
3233
3234
3235
3236
3237
3238
3239
3240
3241
3242
3243
3244
framework.
Calculations
Value of earnout for year 1:
54.71
{See Section 9.7, Capped Call}
[1] Expected present value of EBITDA:
[2] Expected future value of EBITDA (risk-neutral):
[3] Equivalent RMRP-adjusted forecast:
[4] Expected future earnout cash flow (risk-neutral):
[5] Discount factor for credit risk and time value**:
Value of earnout for year 2:
2,065.70
2,081.25
2,081.25
61.09
0.9243
56.47
{ = 2,400 × exp(-10% × 1.5) }
{ = [1] × exp(0.5% × 1.5) }
{ = 2,400 × exp(-9.5% × 1.5) }
{*}
{ = exp(-(3.0%+0.5%) × 2.25) }
[6] Expected future value of earnout payment:
Implied discount rate, excluding credit risk:
82.37
20.42%
{***}
{ = loge([6]/[4])/(2 – 0.5) + 0.5% }
*(30% × Call Option1 ‒ 30% × Call Option2) × exp(0.5% × 1.5). Inputs to Black-Scholes-Merton Call Option formulae: S0 = [1];
Strike1 = 2,400; Strike2 = 3,400; r = 0.5%; σ = 50%; Term = 1.5.
**Credit risk and time value of money from the valuation date to the payment date.
***(30% × Call Option1 ‒ 30% × Call Option2) × exp(10% × 1.5). Inputs to Black-Scholes-Merton Call Option formulae: S0 = [1];
Strike1 = 2,400; Strike2 = 3,400; r = 10%; σ = 50%; Term = 1.5.
9.10 Example: Multi-year, Path Dependent (Capped Call Series with a Catch-Up Feature)
3245
Earnout Payoff Structure
3246
3247
3248
3249
3250
3251
Company A will be required to pay 30% of the excess of the acquiree’s annual EBITDA above
2,000 with a payment cap of 300 for the first year, and 30% of the excess of the acquiree’s annual
EBITDA above 2,400 with a payment cap of 300 for the second year. If the payment cap in the
first year is not reached, then any shortfall as compared to the first-year payment cap will be added
to the payment cap in the second year as a catch-up feature. The payments are due three months
after the end of each earnout period.
3252
Assumptions
3253
3254
3255
Previous years EBITDA:
Forecast annual EBITDA 1st year:
Forecast annual EBITDA 2nd year:
1,800 (illustrative - not needed in the analysis)
2,000
2,400
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3256
3257
3258
3259
3260
Expected volatility of future annual EBITDA: 50%
10%
Discount rate applicable to future EBITDA:
0.5%
Risk-free rate to payment period:
9.5% {= 10% − 0.5%}
Required Metric Risk Premium:
3%
Credit spread of Company A:
3261
Analysis Methodology
3262
3263
3264
3265
3266
3267
Since the earnout is a nonlinear function of EBITDA, a probabilistic framework is needed to
estimate the expected future cash flow of the earnout. The valuation is performed in a risk-neutral
framework to incorporate the impact of the nonlinear payoff structure on the discount rate. In
addition, due to the catch-up feature, the earnout payoff structure is path dependent and therefore
an implementation that can handle path dependency, such as Monte Carlo simulation, is needed to
estimate the value of the earnout.
VFR Valuation Advisory #4 - Valuation of Contingent Consideration
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3268
Calculation of a Single Iteration of a Monte Carlo Simulation:
Calculation Steps
PeriodT =1
PeriodT =2
Description of Calculation Step
Simulating Future EBITDA in Risk-Neutral Framework
[1] Calculation period (yrs)
[2] Payment period
[3] Mid-period
[4] Time-step for simulation
1.0
1.25
0.5
0.5
2.0
2.25
1.5
1.0
Periods at which payments are calculated
Periods at which earnout payments are made
Mid-period of calculation period
Simulation period consistent with mid-period
assumption
[5] Forecast/Expected EBITDA
2,000
2,400
Input assumption
[6] Expected annual growth rate
10.536%
18.232%
loge(2,000/1,800); loge(2,400/2,000); Previous years
EBITDA of 1,800 cancels in [12].
[7] Discount factor for EBITDA:
0.9512
0.8607
=exp(-10% × [3])
[8] Expected PV of EBITDA:
1,902.46
2,065.70
Present value of forecast EBITDA using mid-period
i.e. [5] × [7]
[9] Random Normal (0,1)
0.951
0.856
Standard Normal distribution random numbers
[10] Geometric Brownian Motion
(GBM)
1.3182
1.7936
Risk neutral GBM starting at 1: = [10]t-1 × exp(
(0.5% ‒ 1/2 × 50%2) × [4] + sqrt([4]) × 50% × [9] )
[11] Risk-neutral random EBITDA
2,507.73
3,705.05
[10] × [8]
[12] Equivalent Risk-neutral random
EBITDA using RMRP
2,507.73
3,705.05
Calculating the Present Value of the Earnout Payment
Risk neutral GBM starting at 1,800: = [12]t-1 × exp(
([6] ‒ 9.5% × [4] ‒ 1/2 × 50%2 × [4]) + sqrt([4]) ×
50% × [9] )
[13] Min. EBITDA Threshold
2,000
2,400
Minimum EBITDA threshold for payment
[14] Maximum EBITDA Cap (excl.
catch-up)
3,000
3,400
EBITDA at which cap payment is reached,
excluding the catch-up feature
[15] Earnout payment
(excl. catch-up)
152.32
300.00
30% × ( Max([12] ‒ [13],0) ‒ Max([12] ‒ [14],0) )
[16] Catch-up adjustment to cap
147.68
Max(300 ‒ [15]T=1,0)
[17] Adjusted Maximum EBITDA
Cap (incl. catch-up)
3,892.27
[13] + ([16] + 300) / 30%
[18] Earnout payment (incl. catch-up)
152.32
391.52
T=2: 30% × ( Max([12] ‒ [13],0) ‒ Max([12] ‒
[17],0) )
[19] Discount factor for credit risk
and time value
0.9572
0.9243
At 3.0% + 0.5%= 3.5% over the Payment Period [2]
PV of earnout payments
145.80
361.87
[19] × [18]
PV of earnout for one iteration
507.66
3269
3270
Running the above calculation 10,000 times and averaging over all iterations resulted in an estimated value for
the earnout of 123.67 (results will vary slightly depending on the random numbers generated).
VFR Valuation Advisory #4 - Valuation of Contingent Consideration
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3271
9.11 Example: Clawback (Put Option Structure)
3272
Clawback Payoff Structure
3273
3274
3275
Company A will be entitled to receive 30% of the shortfall of the acquiree’s annual EBITDA below
2,000 over the subsequent one-year period. The payment is due three months after the end of the
year and is payable by the sellers as a potential clawback of the purchase price.
3276
Assumptions
3277
3278
3279
3280
3281
3282
Forecast annual EBITDA:
2,000
Expected volatility of future annual EBITDA: 50%
10%
Discount rate applicable to future EBITDA:
0.5%
Risk-free rate to payment period:
9.5% {= 10% − 0.5%}
Required Metric Risk Premium:
3%
Credit spread of the sellers:
3283
Valuation Methodology
3284
3285
3286
3287
3288
3289
3290
3291
3292
Since the payoff structure is a nonlinear
function of EBITDA, a probabilistic framework
is needed to estimate the expected future cash
flow of the earnout. The valuation is performed
in a risk-neutral framework to incorporate the
impact of the nonlinear payoff structure on the
discount rate. The clawback payoff structure
can be replicated as a put option with strike =
2,000 in an OPM framework.
3293
Black-Scholes-Merton Put Option Formula
3294
3295
3296
3297
3298
3299
3300
3301
3302
3303
3304
3305
3306
3307
3308
3309
3310
3311
3312
3313
3314
−rT
− S0 × N(−d1)
d1 = (log𝑀𝑀(S0 K⁄ ) + (r + 0.5σ
Where
Put Option = K × N(−d2) × e
N(.): standard normal cumulative distribution function
P: payment upon the underlying reaching the strike price
T: term of the option
r: risk-free rate commensurate with term T
2
) × T)/σ√T 𝑎𝑎𝑎𝑎𝑎𝑎 d2 = (log𝑀𝑀(S0 K⁄ ) + (r − 0.5σ
) × T)/σ√T
2
S0: present value of the underlying
K: strike price
σ: volatility of the underlying
loge(.): natural logarithm function
Calculations
[1] Expected present value of EBITDA:
[2] Expected future value of EBITDA (risk-neutral):
[3] Equivalent RMRP-adjusted forecast:
[4] Expected future clawback cash flow (risk-neutral):
[5] Discount factor for credit risk and time value**:
Value of earnout:
1,902.46
1,907.22
1,907.22
96.887
0.9572
92.74
{ = 2,000 × exp(-10% × 0.5) }
{ = [1] × exp(0.5% × 0.5) }
{ = 2,000 × exp(-9.5% × 0.5) }
{*}
{ = exp(-(3.0%+0.5%) × 1.25) }
[6] Expected future value of clawback payment:
Implied discount rate, excluding credit risk:
84.190
-27.59%
{***}
{ = loge([6]/[4])/(1 – 0.5) + 0.5% }
*30% × Put Option × exp(0.5% × 0.5). Inputs to Black-Scholes-Merton Put option formula: S0 = [1]; Strike = 2,000; r = 0.5%; σ
= 50%; Term = 0.5.
**Credit risk and time value of money from the valuation date to the payment date.
*** 30% × Put Option × exp(10% × 0.5). Inputs to Black-Scholes-Merton Put Option formulae: S0 = [1]; Strike = 2,000; r = 10%;
σ = 50%; Term = 0.5.
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3315
3316
3317
3318
3319
3320
3321
3322
3323
3324
3325
3326
3327
3328
3329
3330
3331
3332
3333
3334
3335
3336
3337
3338
3339
3340
3341
3342
3343
3344
3345
3346
3347
3348
3349
3350
3351
3352
3353
3354
Section 10: Appendix
10.1 Frequently Asked Questions
1. None of my bankers or corporate development staff consider option pricing models when
negotiating a deal. Usually the terms of the earnout are the outcome of the negotiation with the
seller, who is probably also not considering option pricing models. How does using an OPM result
in an appropriate fair value when the methodology is not used in practice?
Parties to a business acquisition do not transact the earnout on a standalone basis. From the perspective
of a market participant for the standalone earnout, the observable active market trades that most
resemble (have nonlinear payoff structures like) contingent consideration are traded options and other
derivatives. These are typically priced using an OPM. Furthermore, the scenario-based models
discounted at a WACC or IRR sometimes used by deal participants do not accurately account for the
impact on risk of either (a) differences in time horizon and in leverage between the earnout metric and
long-term free cash flows or (b) nonlinear payoff structures with non-diversifiable underlying metrics.
2. I have carefully constructed scenarios and their associated probabilities that I used in the
negotiation with the seller. Why are they not used in estimating the fair value of the earnout?
For diversifiable metrics (e.g., technical milestones), the scenarios and their probabilities are key
inputs into the valuation of the related earnout. For non-diversifiable metrics (e.g., financial metrics),
the scenarios and their probabilities are primarily used to estimate the expected outcome of the earnout
metric and to help inform the estimate of volatility around this expected outcome. In either case, care
should be taken to minimize common assessment issues such as anchoring on recent results or
overconfidence bias and to cross-check the implied variability in the metric to be sure that the range
of outcomes has not been underestimated. However, for an earnout based on a non-diversifiable metric
with a nonlinear payoff structure (e.g., a financial metric with a threshold, a cap, tiers, or other
nonlinear payoff structure), the use of a scenario-based valuation model can present significant
difficulties with regard to the estimation of an appropriate discount rate.
3. If the contingent consideration is based on future earnings and my expected earnings are exactly
at the earnings threshold, why would the discount rate differ from the WACC or IRR?
The objective is to estimate the fair value of the contingent consideration payments and not of the
underlying earnings. If the payoff structure is not a simple fraction or multiple of earnings, then the
risk of the contingent consideration payments may be fundamentally different than the risk of the
earnings. For example, for an earnout with a threshold (and no cap), the payoff of such an earnout
resembles a leveraged investment with a higher discount rate than for earnings.
4. When estimating the earnout metric discount rate or the required metric risk premium, what
factors should I consider with respect to the additional premiums in the WACC build-up for the
acquiree (i.e., size, country, and/or company-specific premiums)?
The valuation specialist should first consider the rationale for including each of the additional
premiums in the WACC build-up, and then assess whether and to what degree the same rationale
applies to the earnout metric. The factors to consider might include, for example, the extent to which
the acquiree’s business is anticipated to be integrated with the acquirer’s over the term of the earnout
(for size premium) or the extent to which a higher risk due to aggressive projections is relevant to the
earnout metric over the earnout period (for company-specific premium). When there is no clear
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3355
3356
3357
3358
3359
3360
3361
3362
3363
3364
3365
3366
3367
3368
3369
3370
3371
3372
3373
3374
3375
3376
3377
3378
3379
3380
3381
3382
3383
3384
3385
3386
3387
3388
3389
3390
3391
3392
3393
3394
3395
3396
support for fully including or excluding an additional premium, the valuation specialist may deem it
reasonable to proportionately adjust that additional premium in accordance with an estimate of the
risk-differential between the free cash-flows of the acquiree and the earnout metric. For example, if
there is support that the earnout metric is 20% less risky than the acquiree’s long-term free cash-flows,
then proportionately reducing the additional premiums by 20% might be reasonable and practical.
5. The option pricing theory you reference is based on a significant body of academic research. What
academic studies have been published to support using OPM for earnouts?
Since the application of option pricing theory specifically to the valuation of earnouts is relatively new
(first textbook treatment that the Working Group is aware of is a 2005 textbook by Arzac), the body
of academic research is developing. However, there is a robust, more general literature on the
application of option pricing theory to assets and liabilities that are not traded in the market (the
literature on real options).
6. A major assumption underlying OPM is that the earnout metric (e.g., EBITDA, revenue) is
lognormally distributed. What evidence do you have that EBITDA or revenue is lognormally
distributed?
The Working Group does not have substantive evidence that EBITDA or revenue are lognormally
distributed. The application of the lognormal distribution to a company’s stock price, however, is
widely used in practice and EBITDA and revenue are at least somewhat correlated with a company’s
equity value. Where the risk associated with the metric is non-diversifiable and the metric’s
distribution is known to be far from lognormally distributed in a manner that could significantly affect
the valuation, an adjustment may be appropriate. For example, certain deviations from the lognormal
distribution, such as a “lumpy” distribution due to the impact of an event with diversifiable risk (e.g.,
the degree of technical success for an R&D effort) or the need to model negative EBITDA, can be
handled relatively simply.
7. When using an OPM for which the earnout metric is based on profits, isn’t it a problem that a
lognormal distribution assumes the metric cannot go below zero?
While a lognormal distribution does not capture outcomes below zero, the overall impact of excluding
these outcomes may not be significant. A typical profit-based earnout is generally only paid when
profits are substantially positive—making it most important to correctly capture the likelihood of
upside outcomes. In the rare case where contingent consideration is paid for negative profit outcomes
or the impact of excluding negative outcomes is significant (such as, for example, for a clawback), the
analysis could be modified to model an alternative (but related) metric that is unlikely to go negative
(e.g., modeling future revenues and then estimating profits from revenue) or to transform the
distribution into a non-negative distribution consistent with a risk-neutral framework.
8. The use of an OPM generally results in lower values than the values estimated using a scenario-
based method. As a result, later I may have to recognize a loss because the amount ultimately paid
to the seller is much greater than originally estimated. Does this cause a problem from a financial
reporting perspective?
Implemented appropriately with consistent assumptions, the OPM and SBM will give the same result.
For nonlinear payoff structures involving a metric with non-diversifiable risk, the SBM discount rate
needs to be adjusted to account for the impact of the nonlinear payoff structure. This adjustment cannot
be easily intuited and the difficulty of estimating the impact of the payoff structure on risk in an SBM
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framework can be the source of significant differences between the results obtained using OPM and
SBM. Assuming however that the OPM and SBM are implemented appropriately with consistent
assumptions, the initial lower value versus what is expected to be paid out reflects the impact of time
value of money, counterparty credit risk and non-diversifiable risk (including the impact of the payoff
structure on risk) on the value that a market participant would pay for the expected earnout payment
in a fair value transaction. As the uncertainty is resolved positively or in-line with expectations, the
increase in value is entirely consistent with the requirement to update the fair value at specified
reporting periods. Similarly, if the uncertainty is resolved negatively, a decrease in the value of the
earnout liability may cause a gain to be recognized.
9. We do not typically do complex security valuations at my firm and do not have models or software
to perform Monte Carlo simulations. Is it okay to never use such a model?
When the earnout payoff is path dependent or is a function of multiple correlated financial outcomes,
a technique such as Monte Carlo simulation will generally be needed to model the earnout cash flow.
10. When performing a Monte Carlo simulation, what are examples of situations where one would
consider a distribution different than lognormal?
For an earnout payoff based on the outcome of a nonfinancial milestone event with predominantly
diversifiable risk (such as the result of a product development phase), the valuation specialist would
typically consider a discrete distribution for a set of scenarios that represent the possible outcomes for
that event. For an earnout based on a financial metric with a nonlinear payoff structure, the valuation
specialist would generally assume a lognormal distribution. To address situations where the
distribution of a financial metric is “lumpy” or asymmetric due to the impact of a diversifiable risk or
where it is important to consider profit outcomes that are negative, simple adjustments to the standard
implementation of a lognormal distribution may be appropriate. If other issues cause a financial metric
to be far from lognormally distributed in a manner that could significantly affect the valuation, more
complex adjustments or techniques may be appropriate. In general, consideration should be given to
the trade-off between computational complexity versus a more accurate representation of the real-
world metric distribution.
11. I am valuing an earnout for an acquisition that, in addition to market participant synergies, is
expected to realize significant synergies that are unique to the buyer. Should I consider these
buyer-specific synergies in the valuation of the earnout?
Yes, assuming the synergies are included in the earnout agreement’s definition of the metric. Because
an earnout depends on the performance of the acquired business following the acquisition, a market
participant buying or selling the standalone earnout would consider the expected earnout payments
post-transaction, under the new ownership of the actual buyer. Therefore, to the extent that the earnout
payoff is affected by buyer-specific synergies (or dis-synergies), these should be included in the
valuation of the earnout.
12. I strongly believe that we will be making the earnout payment, yet the valuation analysis indicates
a significant discount from the payment amount. Why does that make sense?
The valuation of the earnout is based on the expected payment rather than the most likely payment.
Even when the payment is anticipated to be made, there may still be considerable downside risk.
Further, even if there is no uncertainty about the payment (e.g., for a deferred payment) since the fair
value analysis estimates the price that would be paid for the earnout cash flow by a market participant,
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the fair value of the earnout will always be less than the expected payment due to discounting for the
time value of money and counterparty credit risk.
13. I am valuing an earnout for an acquisition of an early stage life sciences company with one drug
under development by a large pharmaceutical company. A payment of 10 million will be made if
regulatory approval is received. I have estimated the probability of receiving that regulatory
approval. Would it be preferable in this case to use a scenario-based method? What discount rate
should I use?
Yes, it would be preferable to use a scenario-based method. The earnout represents a fixed payment
upon realization of an outcome (i.e., regulatory approval) that is largely a diversifiable risk. The
probability-weighted expected earnout cash flow can be discounted at the obligor’s cost of debt (i.e.,
the risk-free rate plus the counterparty’s credit spread, with adjustments for duration, seniority, etc.).
14. Related to #13 above, what discount rate would you consider if the payments involved a simple
royalty based on a fixed percentage of revenues (assuming the product is successfully launched)?
In this case, the earnout metric (revenue) is exposed to systematic risk and therefore a discount rate
should be used that captures the Required Metric Risk Premium associated with the forecast revenue,
the time value of money over the relevant time horizon (the risk-free rate), and the credit risk of the
obligor. The estimate of the Required Metric Risk Premium will generally differ from the risk premium
used to value the associated business, due to differences in risk between revenue and the long-term
free cash flows of the business. Unless there are buyer-specific synergies incorporated in the revenue
projections for the earnout, long-term free cash flows would generally be riskier than revenues, due to
operational leverage. Thus, even in a linear payoff structure such as a fixed percentage of revenues,
the discount rate for the earnout cash flow (excluding the impact of the obligor’s credit risk) will
typically be lower than the WACC for the relevant business.
15. Can I use a simpler methodology to value an earnout that is almost certain to be paid? For
example, consider an earnout that pays five million at the end of three years if cumulative EBITDA
over the three years exceeds one million. After two years, cumulative EBITDA is 990,000. Nothing
has recently occurred to indicate a change in the outlook for the business over the next year.
In this fact pattern, one can reasonably argue that the probability of payment is so high that the risk of
the earnout cash flow resembles the risk of a plain vanilla debt instrument. In this case it may be
appropriate to assume that the earnout payment will be earned with certainty and to discount the
payment of five million at a rate that reflects the time value of money (risk-free rate) and the obligor’s
credit risk over the remaining one-year time horizon.
16. When updating an earnout valuation, should I assume the same discount rate and counterparty
credit risk as in the original valuation?
All inputs should be reevaluated when updating the valuation. Consideration should be given to
changes in market conditions and to the credit risk of the obligor as well as to changes in the discount
rate, the expected case (mean) forecast of the earnout metric, and (if using OPM) the estimated
volatility around that forecast.
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17. Is adding an additional discount for the buyer’s credit risk double counting since I am already
considering the WACC as part of estimating the risk of the earnout metric? Does this imply that
the buyer will book a gain if its credit quality worsens?
There are two distinct risks being considered in the valuation of the earnout: the risk of the underlying
metric (as modified by the functional form of the payoff) and the risk associated with the obligor’s
ability to make an earnout payment if and when it becomes due. Therefore, there is no double counting.
The dynamics of booking a gain associated with a decline in the buyer’s credit quality is no different
than the dynamics observed when estimating the fair value of debt for financial reporting purposes.
18. How should I estimate counterparty credit risk? Should I consider the credit risk of the buyer or
the seller?
Counterparty credit risk represents the risk associated with the obligor’s ability to make a contingent
consideration payment when it is due. For an earnout, the obligor is typically the buyer. For a
clawback, the obligor is typically the seller. Factors to consider in estimating counterparty credit risk
include the expected timing of the payment(s), the seniority of the obligation, any credit risk mitigation
mechanisms (such as whether or not sufficient funds to cover the potential payment have been placed
in escrow), and any correlation between the outcomes (e.g., the upside scenarios in which an earnout
payment is due) and the obligor’s ability to pay.
19. Should the counterparty credit risk adjustment assume that the earnout payment is subordinated
to the buyer’s outstanding debt?
The seniority of the earnout payment in the obligor’s capital structure should be evaluated based on
discussions with management and/or a review of the relevant documentation. When estimating the
counterparty credit risk, consideration should be given to the level of subordination (e.g., priority of
claims) of the earnout within the obligor’s capital structure.
20. If the expected outcome for the earnout metric is partially locked in, should I take that into
consideration in the valuation of the earnout? For example, a portion of the revenue needed to
achieve the threshold may already be under contract.
Yes. The assessment of the risk of the earnout metric should consider all relevant facts and
circumstances.
21. Since the earnout is a liability, should I apply a premium to the value over the asset value to reflect
what a market participant would require to assume the risk of the liability?
No. The fair value of the earnout as an asset and as a liability should be the same. Also, the accounting
guidance is clear that one needs to value an earnout from the perspective of the asset. For example,
ASC 820-10-35-16B states, “When a quoted price for the transfer of an identical or a similar liability
or instrument classified in a reporting entity’s shareholders’ equity is not available and the identical
item is held by another party as an asset, a reporting entity shall measure the fair value of the liability
or equity instrument from the perspective of a market participant that holds the identical item as an
asset at the measurement date.” Similar guidance is provided in IFRS 13:37.
22. I am valuing an earnout that will pay 10% of EBIT in the first year post-close. I plan to start with
the WACC for the subject business, then adjust for the short-term nature of the earnout to get to a
discount rate appropriate for 1-year EBIT. However, the WACC for the business is a measure of
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the cost of capital for post-tax cash flows. Do I need to make any further adjustment to the discount
rate, since EBIT is a pre-tax metric?
Typically, no, assuming EBIT is unlikely to be negative. Income taxes are usually assumed to be a
linear function of earnings, and therefore typically do not impact risk. In such a situation, the
systematic risk does not differ between the pre-and post-tax cash flows of a business, and therefore a
tax-related adjustment to the post-tax WACC is not appropriate. However, there are cases in which
tax payments can introduce nonlinearities and/or leverage that would significantly affect the risk of
the cash flows of a business; such a situation could require an adjustment to the discount rate to capture
this difference in risk between pre- and post-tax cash flows.
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10.2 Glossary
Terms
Adjusted CAPM
ASC 805
ASC 820
Asset Beta
Backlog
Beta
Binary/Digital Option
Black-Scholes-Merton Formula
Definitions
A framework in which adjustments are made
to the results of the traditional Capital Asset
Pricing Model to incorporate additional risk(s)
beyond volatility and correlation with the
market. Common examples of such additional
risks include risks related to the size of the
relevant business, country-related risk, and
company-specific risk.
FASB Accounting Standards Codification 805
“Business Combinations”
FASB Accounting Standards Codification 820
“Fair Value Measurement”
Also known as unlevered beta, it is derived
from the equity beta by removing the effect of
financial leverage in the capital structure of a
specific company.
Unfulfilled purchase or sales order contracts.
A measure of systematic risk (e.g., the
tendency of a stock price to correlate with
changes in the market).
A type of option in which the payoff is either a
fixed amount if the option expires in the money
or nothing at all if the option expires out of the
money.
A formula which gives a theoretical estimate
of the price of options that can only be
exercised at maturity, derived from the Black-
Scholes-Merton model.
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Buyer-Specific Synergies
Call Option
CAPM
Catch-Up Feature
Clawback
Contingent Consideration
Cost Approach
Counterparty Credit Risk
Credit Spread
Synergies that only a particular buyer would be
able to realize from the transaction.
An agreement that gives the buyer the right,
but not the obligation, to buy an agreed
quantity of an asset from the seller at a certain
time for a certain price.
Capital Asset Pricing Model is a model in
which the cost of capital for any stock or
portfolio of stocks equals a risk-free rate plus a
risk premium that is proportionate to the
systematic risk of the stock or portfolio.
A feature of an earnout agreement which
allows specified shortfalls in payment (as
compared to a payment cap) in prior periods to
be earned in subsequent periods.
The right of an acquirer to the return of
previously
if
specified conditions are met.
consideration
transferred
Contingent consideration usually
is an
obligation of the acquirer to transfer additional
assets or equity interests to the former owners
of an acquiree as part of the exchange for
control of the acquiree if specified future
events occur or conditions are met. However,
contingent consideration also may give the
acquirer the right to the return of previously
transferred
specified
conditions are met.
consideration
if
A general way of determining a value
indication of an individual asset by quantifying
the amount of money required to replace the
future service capability of that asset.
Risk of the obligor being able to make a future
payment when it is due.
risk. Typically measured as
Rate of return above the risk-free rate required
by investors to compensate for counterparty
credit
the
difference between the yields of corporate debt
instruments and the benchmark (risk-free)
government debt security (e.g., U.S. Treasury
bond) of the same maturity.
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DCF
Discount
Diversifiable
Earnout
EBIT
EBITDA
EBT
Enterprise Value
Fair Value
Discounted Cash Flow is a method of valuing
a project, company, or asset by discounting
future cash flow projections at an appropriate
rate to address risk and the time value of
money, in order to arrive at a present value
estimate.
Determine the present value of a cash flow or
stream of cash flows that are projected to be
received in the future.
a portfolio by using
Diversifiable risks are idiosyncratic risks that
can be substantially mitigated or eliminated
adequate
from
diversification. For example, a diversifiable
(but still uncertain) event is one where the
resolution of the uncertainty is typically not
influenced by movements in the markets.
An obligation of the acquirer to transfer
additional assets or equity interests to the
former owners of an acquiree as part of the
exchange for control of the acquiree if
specified future events occur or conditions are
met.
Earnings Before Interest and Tax is a measure
of a firm’s profitability that includes all
expenses except interest and income tax
expenses.
Earnings Before Interest, Tax, Depreciation,
and Amortization is a measure calculated using
a company’s net earnings, before interest
expenses, taxes, depreciation and amortization
are subtracted, as a proxy for a company’s
current operating profitability.
Earnings Before Tax is a measure of a firm’s
profitability that includes all expenses except
for income tax expenses.
An economic measure that reflects the market
value of an ongoing operating business.
The price that would be received to sell an
asset or paid to transfer a liability in an orderly
transaction between market participants at the
measurement date.
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FASB
Financial Leverage
Financial Metric
GBM
IASB
Income Approach
IFRS
IFRS 3R
IFRS 13
IPR&D
IRR
Leverage
that
Financial Accounting Standards Board is the
independent, private-sector, not-for-profit
organization
financial
accounting and reporting standards for public
and private companies and non-for-profit
that follow U.S. Generally
organizations
Accepted Accounting Principles.
establishes
Measurement of the degree to which a
company uses fixed-income securities such as
debt and debt-like instruments.
Refers
to a unit of measurement of a
company’s financial or business performance,
such as revenue, revenue margin, EBITDA,
EBITDA margin, EBIT, net income, units
sold, rental occupancy rates, market share, etc.
Geometric Brownian Motion is a continuous-
time stochastic process in which the logarithm
of the randomly varying quantity follows a
Brownian motion.
International Accounting Standards Board is
the independent, accounting standard-setting
body of the IFRS Foundation.
The valuation approach that uses techniques to
convert future amounts (e.g., cash flows or
single current amount
earnings)
(discounted).
to a
International Financial Reporting Standards
International Financial Reporting Standard 3
(Revised) “Business Combinations”
International Financial Reporting Standard 13
“Fair Value Measurement”
In-Process Research and Development refers
to the incomplete R&D projects of an acquired
business.
The Internal Rate of Return is a discount rate
at which the present value of the future cash
flows of the investment equals the value of the
investment.
Typically, the use of financial instruments or
borrowed capital to increase the potential
return on an investment, representing an equity
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Leverage Ratio
LTFCFE
LTFCFF
Market Approach
Market Participant Synergies
Market Risk Premium (MRP)
Midyear Convention
Moneyness
Monte Carlo Simulation
holder’s exposure to the underlying business as
a result of the presence of debt in the capital
structure. Can also refer to the degree of fixed
costs in a firm’s cost structure.
A financial ratio that quantifies the extent or
reliance on debt financing and/or the degree of
fixed costs in a firm’s cost structure.
Long-Term Free Cash Flow to Equity is a
measure of how much cash can be paid to the
equity shareholders of a company after all
expenses, reinvestment and debt are paid.
Long-Term Free Cash Flow to the Firm is a
measure of how much cash can be paid to the
investors in a company (including debtholders,
equity holders, and other non-equity investors)
after all expenses and reinvestment are paid.
A valuation approach that uses prices and other
relevant information generated by market
transactions involving identical or comparable
assets or liabilities.
Synergies that can be realized by a pool of
hypothetical buyers and sellers
(market
participants with certain characteristics) in the
principal (or most advantageous) market.
The Market Risk Premium, also known as the
Equity Risk Premium, is the rate of return
above the risk-free rate that is required by
investors for holding the market portfolio (i.e.,
a large portfolio of diversified stocks, typically
represented by a broad stock market index).
A convention that reflects economic benefits
being generated at midyear, approximating the
effect of economic benefits being generated
evenly throughout the year.
The relative position of the current price (or
future price) of an underlying asset with
respect to the strike price of an option.
A technique used to sample randomly from a
probability distribution, to produce different
possible outcomes.
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Noncontrolling Interest
Non-diversifiable
Nonfinancial Milestone Event
Operational Leverage
OPM
Orderly Transaction
Path Dependency
The portion of equity (net assets) in a
subsidiary not attributable, directly or
indirectly, to a parent. A noncontrolling
interest is sometimes called a minority interest.
Risks that cannot be fully mitigated or
eliminated through diversification. Typically
these are risks that are correlated with the
market. For example, revenue is exposed to
both company-specific risk as well as to
market risk.
Refers to an event that is not defined based on
the outcome of a Financial Metric, such as
regulatory approvals, resolution of
legal
disputes, execution of certain commercial
contracts or retention of customers, closing of
transaction, or achievement of
a future
technical milestones.
Measurement of the degree to which a firm or
project incurs a combination of fixed and
variable costs. A company with high fixed
costs relative to its earnings has a high degree
of operational leverage.
Option Pricing Method is a method whereby
the valuation specialist applies an appropriate
discount rate to the contingent consideration
metric forecast in order to establish a risk-
neutral forecast distribution for the metric,
estimates the expected payoff cash flow in this
risk-neutral framework, and discounts the risk-
neutral expected payoff cash flow at the risk-
free rate, plus any adjustment for counterparty
credit risk.
A transaction that assumes exposure to the
market for a period before the measurement
date to allow for marketing activities that are
usual and customary for transactions involving
such assets or liabilities; it is not a forced
transaction (e.g., a forced liquidation or
distress sale).
An arrangement that includes multiple earnout
periods and in which at least some of the
contingent
the
interrelated performance over multiple of these
periods.
payments
depend
on
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PV
PFI
Required Rate of Return
Revenue Beta
RFR
Risk-Adjusting Discount Rate
Risk-Neutral Framework
RMRP
SBM
Size Premium
Standard Deviation
Standard Normal Distribution
Present Value is the value of future economic
benefits and/or proceeds as of a specified date,
calculated using an appropriate discount rate.
Prospective Financial Information is a forecast
of expected future cash flows.
The rate of return required by an investor to
compensate for the time value of money and
the non-diversifiable risk of investing in a
particular investment.
A measure of the systematic risk of company
revenue relative to the market.
The Risk-Free Rate is the rate of return
required by investors to compensate for the
time value of money on a risk-free investment.
The Required Metric Risk Premium plus the
Risk-Free Rate
A framework in which non-diversifiable risk is
first removed from a contingent consideration
metric, the contingent consideration payoffs
are then calculated based on the risk-adjusted
metric, and finally the payoffs are discounted
at the risk-free rate (plus any adjustments for
counterparty credit risk).
Required Metric Risk Premium is a measure of
the excess return, or risk premium, that
investors demand to bear the non-diversifiable
risk associated with a specific metric.
Scenario-Based Method is a method whereby
the valuation specialist identifies multiple
outcomes, probability weights these outcomes
to arrive at an expected payment cash flow, and
discounts the result at an appropriate rate.
The additional return required to compensate
an investor for the additional risk associated
with smaller companies.
A measure that quantifies the amount of
variation or dispersion of a set of data values
from their mean.
A special case of the normal distribution that
occurs when a normal random variable (a very
common, continuous probability distribution
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Strike Price
Systematic Risk
Term
Unit of Account
U.S. GAAP
Volatility
WACC
WARA
with a symmetrical, bell shape) has a mean of
0 and a standard deviation of 1.
The price at which the holder of an option can
buy or sell the underlying security.
Risks that cannot be fully mitigated or
eliminated through diversification because
they are correlated with the market. For
example, revenue is exposed to both company-
specific risk factors as well as to market risk.
The remaining time to expiry of an instrument
or security.
The level at which an asset or liability is
aggregated or disaggregated for accounting
recognition purposes.
United States Generally Accepted Accounting
Principles
The standard deviation of asset returns or
metric growth rates.
Weighted Average Cost of Capital is the return
required by both debt and equity investors,
weighted by their respective contributions to
the overall capital structure.
Weighted Average Return on Assets is the cost
of capital determined by the weighted average,
at market value, of the collective rates of return
on the various types of tangible and intangible
assets of a company.
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10.3 Technical Notes
The Technical Notes section contains detailed technical discussions related to various methodologies
including:
• Estimating the RMRP for an earnings-based metric using the Hamada, Modigliani-Miller
Generalized Beta, Practitioners’ and Volatility-Based Methods
• Estimating the RMRP for a revenue-based metric using the Fixed Costs vs. Assets Method
and Volatility-based Methods
• Estimating the RMRP for any metric via a bottom-up estimation technique
• Risk-adjusting the metric forecast (to create a risk-neutral metric forecast for use in an OPM),
using either of two equivalent techniques
• The applicability of the normal distribution to financial metrics: pros and cons
• The properties of a Geometric Brownian Motion, including how to handle situations where
these properties do not hold (alternative methods)
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• A discussion of the academic literature and its support for the application of option pricing
methods to the valuation of non-traded assets and liabilities.
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10.3.1 Estimating Earnings-Based RMRPs by De-Levering for Financial Leverage
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The methods for estimating earnings-based RMRPs by de-levering the equity RMRP for financial
leverage described below include the Hamada, Modigliani-Miller Generalized Beta, Practitioners’ and
Volatility-Based Methods. There are numerous other methods for de-levering for financial leverage
that can be employed, such as the Miles-Ezzel, Harris-Pringle, and Fernandez methods.125,126 Each of
these methods relies on differing underlying assumptions, requires differing levels of complexity to
estimate, and can produce different estimates for the RMRP.
In choosing among these methods, it is important to ensure that the assumptions associated with the
selected method are reasonable given the earnout timeframe and the capital structure of the subject
business. Any potential issues with a method’s assumptions should be thought through prior to
applying the methodology. The following is a summary of the main considerations associated with
these four de-levering methods (which are discussed in more detail in the remainder of this section):
• The Hamada Method assumes that the company will always be able to realize an interest tax
deduction in the period intended, debt has no systematic risk, and the debt amount is constant
over time.
• The Modigliani-Miller Generalized Beta Method assumes constant financial leverage and
requires an estimate of the required risk premium for debt.
• The Practitioners’ Method assumes that debt has no systematic risk and that tax shields have
the same risk as operating assets.
• The Volatility-Based Method assumes that the correlation between the market and the earnout
metric is the same as the correlation between the market and the company’s return on equity
and requires an estimate of volatility in growth rate for the metric.127
Depending on the underlying characteristics of the financial leverage associated with the earnout
metric, an alternative method may be appropriate. For example, the Hamada, Modigliani-Miller
Generalized Beta and Practitioners’ Methods all estimate the same RMRP for all earnings-based
metrics—which might be an issue, e.g., where the metric is EBITDA and depreciation or amortization
are substantial. In such a situation, the Fixed Costs vs. Assets Method (see Section 10.3.2) can be used
to further adjust the RMRP for EBIT estimated with one of these three methods to obtain a RMRP for
EBITDA.
The Hamada, Modigliani-Miller Generalized Beta, Practitioners’ and Volatility-Based Methods are
described below in terms of estimating the RMRP. Because the theories are predicated on the CAPM
framework, the reader may be more familiar with the application of these methods to estimating betas.
Indeed, that is how they are typically portrayed and understood in the financial literature.
In general, similar principles should be applicable even under alternatives to the CAPM framework
for the analysis of systematic risk.
125 See Pratt and Grabowski, Cost of Capital, 5th ed. (2014), pp. 248-254.
126 The WACC less the long-term risk-free rate is another alternative estimate that could be used to approximate the RMRP of an
earnings-based metric. This method is described in Section 5.2.3.1. When using this method, the valuation specialist should
consider whether adjustments are needed for differences in the risk of the earnout metric as compared to the risk associated with the
long-term free cash flows to the firm.
127 If the valuation specialist is using OPM (e.g., because the payoff structure is nonlinear), an estimate of metric volatility will often
be required for the analysis anyway. However, if using SBM to value an earnout with a linear payoff structure, an estimate of metric
volatility would generally not be required unless it is needed for the method used to estimate the RMRP.
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Hamada Method
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The Hamada Method uses the following equation to de-lever the equity RMRP for financial
leverage:128
RMRPEBIT·= RMRPEquity / [1 + (1-t)×D/E]
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Where:
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RMRPEBIT = the risk premium (above the risk-free rate) appropriate to EBIT
RMRPEquity = the risk premium (above the risk-free rate) appropriate to long-term free cash
flows to equity
t = the relevant tax rate
D/E = the debt-to-equity ratio of the subject company.
The advantage of this methodology is that it is relatively straightforward to calculate and it is a well-
known methodology with which many practitioners are familiar. However, this formulation assumes
that the company will always be able to realize an interest tax deduction in the period intended, that
the debt of the company has no systematic risk (or in a CAPM framework, that the beta on debt is
always zero), and that the debt amount is constant over time, which is equivalent to assuming a
decreasing debt-to-equity ratio as the company grows in size. The Hamada Method also estimates the
same RMRP for different earnings-based metrics (e.g., EBIT vs. EBITDA), which might be an issue
where there is a significant difference in leverage between these metrics (e.g., if depreciation or
amortization are substantial). These assumptions may or may not be reasonable.
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Modigliani-Miller Generalized Beta Method
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An alternative method for de-levering for financial leverage that relies on estimates for both equity
and debt RMRPs (or, in a CAPM framework, on both equity and debt betas) is proposed below:129
RMRPEBIT·= RMRPDebt × D/V + RMRPEquity × E/V
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Where:
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V = the firm’s total value
D/V = the percentage of the firm’s value comprised of debt
E/V = the percentage of the firm’s value comprised of equity.
The fundamental underpinning of this methodology is that the returns on debt are correlated with
market returns, and the methodology therefore allows for factoring in the systematic risk of debt. This
methodology also assumes a constant financial leverage ratio. As for the Hamada method, the
Modigliani-Miller Generalized Beta Method calculation is straightforward;130 however, this method
requires estimation of a RMRP for debt (or, in a CAPM framework, a debt beta).131 The Modigliani-
Miller Generalized Beta Method also estimates the same RMRP for different earnings-based metrics
128 See Hamada (1972). The formula is typically expressed in terms of equity and asset betas, as follows:
Asset beta = Equity beta / [1 + (1-t)×D/E].
129 See Brealey, Myers, and Allen, Principles of Corporate Finance, pp. 225-226. The formula is typically expressed in terms of equity
and asset betas, as follows: βAsset·= βDebt × D/V + βEquity × E/V.
130 In fact, the Hamada Method is a special case of the Modigliani-Miller Generalized Beta Method, where (a) debt is considered to be
risk-free; and (b) tax shields have the same risk as debt. See McKinsey & Company, Valuation: Measuring and Managing the Value
of Companies, 5th ed. (2010), Appendix D.
131 For estimates of debt betas based on credit ratings, see, for instance, Pratt and Grabowski, Cost of Capital, 5th ed. (2014), p. 221.
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(e.g., EBIT vs. EBITDA), which might be an issue where there is a significant difference in leverage
between these metrics (e.g., if depreciation or amortization are substantial).
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Practitioners’ Method
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The Practitioners’ Method, so named because it is often used in practice, uses the following method
for de-levering for financial leverage:132
RMRPEBIT·= RMRPEquity / [1 + D/E]
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Where:
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RMRPEBIT = the risk premium (above the risk-free rate) appropriate to EBIT
RMRPEquity = the risk premium (above the risk-free rate) appropriate to long-term free cash
flows to equity
D/E = the debt-to-equity ratio of the business.
The Practitioner’s Method is a special case of the Modigliani-Miller Generalized Beta Method, where
the valuation specialist assumes that (a) debt has no systematic risk (this assumption is also made by
the Hamada Method) and (b) tax shields have the same risk as operating assets.133
On the plus side, this is also a relatively straightforward calculation, and is well known to practitioners.
However, the assumption of no systematic risk for debt and the fact that it does not factor in the impacts
of any tax deduction of interest payments may or may not be reasonable. The Practitioner’s Method
also estimates the same RMRP for different earnings-based metrics (e.g., EBIT vs. EBITDA), which
might be an issue where there is a significant difference in leverage between these metrics (e.g., if
depreciation or amortization are substantial).
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Volatility-Based Method
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The Volatility-Based Method is predicated on the assumption that differences in risk due to leverage
are fully captured by differences in volatility of the underlying metrics. In a CAPM framework, this
assumption implies that the correlation between the subject metric (e.g., EBIT) and the market is the
same as the correlation between the return on equity (if starting with an equity RMRP) and the market.
RMRPEBIT·= RMRPEquity × σEBIT/σEquity
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Where:
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σEBIT = the volatility of the EBIT of the company134
σEquity = the volatility of the equity of the company.
If this method is selected, care should also be taken to ensure that sufficiently reliable data is available
to estimate volatility in the growth rate for the metric. Note that if the valuation specialist is using
OPM (e.g., because the payoff structure is nonlinear), an estimate of volatility in the growth rate for
the metric will often be required for the analysis anyway. However, if using SBM to value an earnings-
based earnout with a linear payoff structure, an estimate of volatility in the growth rate for the metric
would generally not be required, unless it is needed for the method used to estimate the RMRP.
132 See Pratt and Grabowski, Cost of Capital, 5th ed. (2014), pp. 248-254. The formula is typically expressed in terms of equity and asset
betas, as follows: Asset beta = Equity beta / [1 + D/E].
133 See McKinsey (2010), Valuation: Measuring and Managing the Value of Companies, Appendix D.
134 Note: the volatility of the earnings-based metric can be estimated either by de-levering equity volatilities or by estimating volatilities
specific to the metric itself (i.e., EBITDA or EBIT, etc.)
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On the plus side, the Volatility-Based Method allows for capturing the intricate differences in risk
associated with different types of earnings (e.g., EBIT vs. EBITDA). However, the method relies on
the simplifying assumption that the correlation between the market and the earnout metric is the same
as the correlation between the market and the company’s return on equity, which may or may not be
reasonable.
3650
See Section 5.2.4 for estimating volatility.
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10.3.2 Estimating Revenue-Based RMRPs by De-Levering EBIT RMRPs for Operational Leverage
Methods for estimating revenue RMRPs by de-levering EBIT RMRPs135 for operational leverage
include the Fixed Costs vs. Assets Method and the Volatility-Based Method. These two methods are
described below. An alternative method, the Harris-Pringle formula (which was designed to estimate
operating betas), is not recommended by the Working Group for estimating a RMRP for a revenue
metric.136 See also Section 5.2.3.5 for a more general discussion of the pros and cons of using a de-
levering methodology for estimating the RMRP for a revenue-based metric.
In choosing between these methods, it is important to ensure that the assumptions associated with the
selected method are reasonable given the earnout timeframe and the capital structure of the subject
business. Any potential issues with a method’s assumptions should be thought through prior to
applying the methodology. The following is a summary of the main considerations associated with
these two methods (which are discussed in more detail in the remainder of this section):
• The Fixed Costs vs. Assets Method assumes that the systematic risk associated with fixed
costs is approximately zero and generally requires an estimate of the percentage of costs that
are fixed versus variable over the time horizon(s) relevant to estimating the earnout payoff
(which can be challenging to estimate, given the typical difficulties in distinguishing between
fixed and variable costs).
• The Volatility-Based Method assumes that the correlation between the market and the earnout
metric is the same as the correlation between the market and the company’s return on equity
and the method also requires an estimate of volatility in the growth rate for the metric.137
Note that both the Fixed Costs vs. Assets Method and the Volatility-Based Method can also be used
to estimate the RMRP for other metrics besides revenue, such as gross profit, net income, etc., as long
as adjustments are made for the relative risk and leverage of the relevant earnout metric.
These two methods are described in this section in terms of estimating the RMRP. Because the theories
are predicated on the CAPM framework, the reader may be more familiar with the application of these
135 In lieu of starting with an EBIT RMRP, it may often be reasonable to start with the WACC less the long-term risk-free rate, make
any adjustments for differences in duration or financial leverage, and then de-lever for differences in operational leverage.
136 The Harris-Pringle formula is as follows:
βOperating·= βUnlevered / [1 + Fixed Costs/Variable Costs]
Where:
βOperating = the operating beta of the company
βUnlevered = the unlevered beta
Fixed Costs/Variable Costs = the ratio of fixed operating costs (without regard to costs of financing) to variable operating
costs
Unfortunately, the Harris-Pringle method can be problematic in the context of estimating revenue betas as it doesn’t directly relate
fixed costs or variable costs to either revenue or EBIT, but rather only to each other. As such, this method would give the same result
whether total costs are 1% of revenue or 100% of revenue. It may not result, therefore, in a reasonable estimate of a revenue RMRP.
137 If the valuation specialist is using OPM (e.g., because the payoff structure is nonlinear), an estimate of metric volatility will often
be required for the analysis anyway. However, if using SBM to value an earnout with a linear payoff structure, an estimate of metric
volatility would generally not be required unless it is needed for the method used to estimate the RMRP.
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methods to estimating betas. Indeed, that is how they are typically portrayed and understood in the
financial literature.
Similar principles should generally be applicable even under alternatives to the CAPM framework for
the analysis of systematic risk. That is, if an alternative framework for modeling systematic risk is
used for a revenue-based metric, consideration should be given as to how to adjust the risk premiums
for long-term free cash flows for operational leverage. For example, in an Adjusted CAPM framework,
if a size premium is appropriate for valuing the business, consideration should be given to adjusting
the size premium commensurate with the differences in risk between long-term free cash flows and
the revenue metric. While the Fixed Costs vs. Assets Method and/or the Volatility-Based Method can
be appropriate for such adjustments, depending on the framework and the specific situation, it is
possible that an alternative method might be more appropriate for adjusting the additional risk
premiums.
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Fixed Costs vs. Assets Method
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This method is designed to estimate a RMRP for revenue via further adjustment to the RMRP for an
EBIT metric, for operational leverage over the term of the earnout. The key assumption underlying
this method is that the systematic risk associated with fixed costs is approximately zero (which may
or may not be reasonable). Under this assumption, the RMRP for revenue can be estimated as:138
RMRPRevenue·= RMRPEBIT / [1 + PV(fixed costs) / PV(EBIT)]
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Where:
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PV(fixed costs) = the present value of fixed costs during the earnout period
PV(EBIT) 139 = the present value of EBIT during the earnout period, where PV(EBIT) =
PV(revenue) − PV(fixed costs) − PV(variable costs).
The RMRP for EBIT can be estimated as discussed in Section 10.3.1. To estimate the operational
leverage ratio of PV(fixed costs)/PV(EBIT), often one starts by estimating the percentage of costs that
are fixed versus variable over the relevant time periods. Then one can derive the present value of the
fixed costs by discounting the fixed costs over the period of the earnout; given the assumption that the
systematic risk associated with fixed costs is approximately zero, the discount rate for fixed costs can
be reasonably approximated by the estimated cost of debt of the entity whose obligation it is to pay
these fixed costs. The present value of the EBIT can be estimated by discounting the EBIT over the
period of the earnout at the estimated discount rate appropriate to EBIT.
Difficulties may arise in using this methodology, as distinguishing fixed from variable costs may be
challenging. In theory, over a long time horizon, all costs become variable. Over a medium or short
time horizon, though, usually some costs are fixed and some are variable. As such, it is important to
consider which costs are fixed vs. variable over the term of the earnout period.
Furthermore, many earnouts are associated with the performance of early-stage businesses for which
EBIT can often be either negative or very small. For such businesses, the denominator of this ratio
may produce unreasonable results.
Finally, even though this methodology is couched in terms of revenue, it could be adapted for any
financial metric based on the relative operational leverage over the term of the earnout. For instance,
138 Or, in a CAPM framework, as βRevenue = βAsset / [1 + PV(fixed costs) / PV(asset)]. See Brealey, Myers, and Allen, Principles of
Corporate Finance, pp. 226-229 for further detail on asset beta and revenue beta estimation.
139 PV(EBIT) is generally seen as a reasonable measurement of the present value of the underlying assets of the related business, on
which the formula is predicated.
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if the underlying metric were gross profit, instead of using all fixed costs, you would instead use only
the fixed component of operating expenses. Similarly, this method could be utilized to handle the
situation where the metric is EBITDA and depreciation or amortization expenses are substantial, by
adjusting a RMRP relevant to EBIT to arrive at a RMRP relevant to EBITDA.
3719
Volatility-Based Method
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The Volatility-Based Method assumes that differences in leverage can be captured solely via relative
differences in volatility, which in the CAPM framework means that the correlation between the metric
of interest (e.g., revenue) and the market is the same as the correlation between the return on equity
(if starting with an equity beta) or the return on assets (if starting with an asset beta) and the market.
This assumption may or may not be reasonable.
When using this methodology, care should also be taken to ensure that sufficiently reliable data is
available to estimate the volatility in the growth rate for the metric. Note that if the valuation specialist
is using OPM (e.g., because the payoff structure is nonlinear), an estimate of volatility in the growth
rate for the metric will often be required for the analysis anyway. However, if using SBM to value a
revenue-based earnout with a linear payoff structure, an estimate of volatility in the growth rate for
the metric would generally not be required, unless it is needed for the method used to estimate the
RMRP.
One possible implementation of the Volatility-Based Method starts with an EBIT RMRP as estimated,
for example, by one of the methodologies in Section 10.3.1. The RMRP for the metric is then estimated
as follows:
RMRPmetric·= RMRPEBIT × σmetric /σEBIT
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Where:
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σmetric = the volatility in the growth of the metric of the company
σEBIT = the volatility of returns on the assets of the company.
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Alternatively, in a CAPM framework one can instead begin with an equity beta:
3740
βmetric·= βEquity × σmetric /σEquity
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Where:
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σmetric = the volatility in the growth of the metric of the company
σEquity = the volatility of returns on the equity of the company.
A useful cross-check when using the Volatility-Based Method is to compute the operational leverage
ratio implied by the Volatility-Based Method, test it for reasonability, and potentially also compare it
to the operational leverage ratio implied by the Fixed Costs vs. Assets Method. These respective
operational leverage ratios may be calculated as follows:
Volatility-Based Method implied operational leverage ratio = σEBIT /σmetric – 1
Fixed Costs vs. Assets Method implied operational leverage ratio = PV(fixed costs) / PV(EBIT)
This check can help ensure that the estimated de-levering adjustment makes sense for the business
over the earnout period.
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10.3.3 The Bottom-Up Method for Estimating a RMRP for Any Metric
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The bottom-up method is described in this section in terms of estimating metric betas, from which the
Required Metric Risk Premium can be calculated in a CAPM (or Adjusted CAPM) framework. The
discussion is predicated on assumptions underlying the CAPM framework because that is how it is
typically portrayed and understood in the literature.
Similar principles should generally be applicable under alternatives to the CAPM framework for the
analysis of systematic risk; whatever method was used for estimating the risk of the long-term free
cash flows of the business, the bottom-up technique should be adaptable enough to develop direct
estimates of the risk associated with the underlying metric. For example, in an Adjusted CAPM
framework, if a company-specific premium is appropriate for valuing the business, consideration
should be given to incorporating in the RMRP the portion of that premium that is relevant to the
earnings metric. Methods for incorporating such additional risk premiums are discussed in Section
5.2.3.
In any case, care should be taken to ensure that the underlying assumptions of the bottom-up method
are reasonable in the given circumstance, and that any differences in underlying assumptions are
thought through prior to applying the methodology.
In contrast to the top-down methods of Sections 10.3.1 and 10.3.2 that are specific to estimating
RMRPs for earnings-based and revenue-based metrics respectively (or equivalently in a CAPM
framework, estimating asset/earnings betas and revenue betas), a bottom-up method can be used
regardless of the metric on which the earnout is based. The bottom-up method directly measures the
beta of the underlying metric, and therefore does not rely on the equity beta (or the WACC or the IRR)
as a starting point.
The bottom-up method estimates a beta associated with any type of metric (such as revenue, EBIT, or
EBITDA) by using CAPM to estimate the systematic risk associated with the underlying metric. This
method is consistent with the “real options” pricing method.140 The metric beta can be estimated as
follows:
βMetric·= ρ(Metric, Market) × sMetric ÷ sMarket
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Where:
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ρ(Metric, Market) = the instantaneous correlation between the percent changes in the metric and the
returns on a broad index of stock market prices
sMetric = the volatility of the growth in the metric
sMarket = the volatility of the return on a broad index of stock market prices.
In circumstances where there is significant debt in the capital structure, the valuation specialist should
consider whether it would be appropriate to make an adjustment to the estimated RMRP due to the
impact of the availability of debt financing. For example, the valuation specialist could rely on an
appropriately weighted average of the RMRP for the earnout metric and the cost of debt.
While it can be challenging to correctly estimate the correlation between the growth in the relevant
metric and the return of the market or to estimate the volatility in growth in the metric, historical data
140 See Hull, Options, Futures, and Other Derivatives, 8th ed. (2011), pp 766-768 for further detail on the Real Options methodology for
valuing assets based on financial metrics not priced in the market. Note: the terminology in this Valuation Advisory differs slightly
from the terminology used by Hull. In particular, what Hull refers to as the market price of risk (HMPR) is only a component of what
is referred herein as the Required Metric Risk Premium (RMRP). The specific relationship is: RMRP = HMPR × sMetric.
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for the company in question, comparable companies, or the industry can often be used to inform the
estimates if adequate historical data is available. Adjustments are typically made to remove historical
outliers and/or data points with a large impact due to nonrecurring, idiosyncratic issues such as major
acquisitions, divestitures, or product announcements. Furthermore, when estimating historical
correlation, if using quarterly data, the analysis should use year-on-year quarterly growth (e.g., Q1 of
the current year vs. Q1 of the prior year) rather than quarter-to-quarter growth (e.g., Q1 of the current
year vs. Q4 of the prior year) to avoid artificial impacts on correlation due to seasonality.
When estimating the historical correlation in metric growth for the company and comparable
companies with a broad market index, the first question to consider is what index might be most
appropriate. The S&P 500 index may be appropriate for a U.S.-based company that conducts most of
its business in the U.S., but perhaps not for a company that conducts most of its business in Europe or
Asia. Furthermore, one may need to investigate lagged effects to obtain a proper estimate of
correlation.141
As discussed above, if an alternative framework for modeling systematic risk is used, consideration
should be given as to what portion of that framework’s risk premiums to incorporate in the RMRP.
For example, in an Adjusted CAPM framework, if a size premium is appropriate for valuing the
business, consideration should be given to incorporating a portion of the size premium into the RMRP
for revenue—the portion commensurate with the amount of the risk represented by the size premium
that is applicable to the revenue metric. Methods for incorporating such additional risk premiums are
discussed in Section 5.2.3.
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See Section 5.2.4 for a discussion of estimating volatility in the growth rate for the metric.
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See Section 5.2.3.6 for the pros and cons of using a bottom-up method for estimating a RMRP.
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10.3.4 Two Methods for Risk-Adjusting the Metric Forecast
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As discussed in Section 5.4.1, the OPM is appropriate for valuing contingent consideration based on
a nonlinear payoff structure with metrics that involve non-diversifiable risk.
There are two ways of adjusting management’s forecast for the metric to account for non-diversifiable
risk:
• Forecast Risk Adjustment (1) – Management’s forecast for the metric is discounted at an
appropriate risk-adjusting discount rate, which results in a risk-neutral forecast of the metric
that is forward looking.
• Forecast Risk Adjustment (2) – Management’s forecast growth rate of the metric is adjusted
by the Required Metric Risk Premium.
While appearing different, these two risk-adjustment methodologies are in fact equivalent; they
provide the same risk-neutral future value for the metric. The equivalence will first be illustrated with
an example, after which the mathematical equivalence will be demonstrated.
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Example Earnout Payoff Structure
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Company A will be required to pay 30% of the excess of the acquiree’s annual EBITDA above
2,000 over the next year. The payment is due three months after the end of that year.
141 There is some evidence that stock market returns are a leading indicator of revenue growth, with a lead time of approximately one
quarter (equivalently, revenue growth lags related stock market movements by approximately one quarter).
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Assumptions
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Management provided historical EBITDA of 1,800 as of the end of the previous period and
forecasted EBITDA of 2,000 as of the end of the following period. The RMRP associated with the
acquiree’s EBITDA is 9.5%, the risk-free rate consistent with the timeframe to payment of the
earnout is 0.5% (i.e., the risk-adjusting discount rate applicable to future EBITDA is 10%), and
the credit spread of Company A for a subordinated obligation such as this earnout is 3.0% (all
these rates are per annum, continuously compounded).
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Forecast Risk Adjustment (1)
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The present value of the forecasted EBITDA, assuming EBITDA is earned at the mid-period (i.e.
using the mid-period convention) is calculated as:
1,902.5 = 2,000 × exp(-10.0%×0.5)
The OPM is applied, assuming a lognormal distribution of the metric.142 The risk-neutral present
value of forecasted EBITDA is used to simulate the value for the risk-neutral future EBITDA as:143
2,507.73 = 1,902.5 × exp((0.5% - (50.0%)2/2)×0.5 + 50.0%×(0.5)1/2×0.951)
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Forecast Risk Adjustment (2)
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The continuous (annualized) growth rate of management’s forecast for the metric is:
10.536% = loge(2,000 / 1,800)
The growth rate of management’s forecast for the metric is adjusted by the RMRP (equal to 9.5%
in this example) and is used to simulate the value for the risk-neutral future EBITDA as:144
2,507.73 = 1,800 × exp((10.536% –9.5%×0.5+(50.0%)2/2×0.5 + 50.0%×(0.5)1/2×0.951)
The one path simulated risk-neutral future EBITDA is the same for the two forecast risk adjustment
methods above. For this simulated path:
• the contingent consideration payoff for the random draw of 0.951 is
152.32 = 30.0% × max{2,507.73 – 2,000, 0}
• the present value of the contingent consideration payment for this random draw is
145.8 = 152.32 × exp(-(3.0%+0.5%)×1.25)
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Equivalence of the Two Forecast Risk-Adjustment Methods for an OPM
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In the example above, both forecast risk adjustment methods provide the same risk-neutral future
EBITDA. The equivalence of the two methods, in terms of providing the same risk-neutral future
values for the metric, hinges upon the following relation between the Required Metric Risk
Premium and the risk-adjusting discount rate applicable to the metric:
142 A discussion on the use of the lognormal distribution for non-traded metrics (e.g., revenue, EBIT, EBITDA) is provided in Section
5.4.
143 For illustration purposes we assume an EBITDA volatility of 50.0% and 0.951 as a random draw from a standard normal distribution.
The calculated value represents only one simulated path assuming EBITDA is earned at the mid-period; the valuation specialist will
choose an appropriate number of iterations (paths) that ensures the required convergence of results.
144 The adjusted growth rate is applied to the actual EBITDA as of the end of previous period. For consistency with Forecast Risk
Adjustment (1), we continue to assume an EBITDA volatility of 50.0% and 0.951 as a random draw from a standard normal
distribution. The calculated value represents only one simulated path assuming EBITDA is earned at the mid-period; the valuation
specialist will choose an appropriate number of iterations (paths) that ensures the required convergence of results.
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Required Metric Risk Premium = Risk-adjusting discount rate – Risk-free rate
The implication is that neither of the two methods should be considered superior since the two
methods are theoretically equivalent. In practice, it can be the case that practitioners using the two
methods come to different conclusions, but this is due to differences in the methodology used to
estimate the RMRP (see Section 5.2.2), not to differences caused by otherwise logically equivalent
methods.
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10.3.5 The Applicability of the Normal Distribution to Financial Metrics
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The assumption that returns (or growth rates) of a financial investment are normally distributed has
been debated since the advent of modern portfolio theory. The normal distribution assumption is
generally applied as a simplification to ensure tractable results; any alternative assumption
significantly increases the complexity of the model.145
In finance, the most common criticism of the normal distribution assumption is that it is not a heavy-
tailed distribution and therefore does not adequately capture the significant deviations from the mean
that have been empirically observed in financial markets. Despite this well-founded criticism as well
as the existence of heavy-tailed alternative models, the general applications of the Capital Asset
Pricing Model (CAPM) and the Black-Scholes-Merton Options pricing framework make use of the
normal distribution assumption, and are among the most widely used models in finance today. The
main reasons for maintaining the normal distribution assumption, despite contradictory empirical
evidence and better fitting models, is ease of use and intuitive results. Extensive research, closed-form
solutions, and convenient mathematical properties have also contributed to the wide application of the
normal distribution in finance.
To date there have been two main criticisms of the normal distribution assumption as applied to
financial metrics such as revenue or EBITDA, namely, (a) that the tails of the normal distribution are
too heavy146 and can result in metric growth rates that are too extreme; and (b) assuming that growth
rates of the underlying metric are normally distributed results in a lognormal distribution for the
underlying metric, which precludes the possibility of the underlying metric going negative.
For the first (“tails too heavy”) criticism, there are few models commonly used in practice that have
tails thinner than a normal distribution. However, a financial metric that has thin tails can in most cases
be adequately modeled using a normal distribution with a commensurately low volatility assumption.
There may be cases, however, where the underlying metric has a definite limit (e.g., a production
constraint could limit the near-term upside for revenues) and the probability of reaching this limit is
significant. In such cases, the use of the normal distribution might not be appropriate. An alternative
is to transform the (constrained or thin-tailed) distribution in a manner that is consistent with modeling
in a risk-neutral framework, as discussed in Wang (2002).
For the second criticism, it is true that a lognormal distribution cannot fully represent the distribution
of a metric that can go negative, such as an earnings-based metric. Fortunately, earnouts are typically
structured to incentivize substantially positive earnings, in which case the impact of modeling negative
outcomes as if they were small, positive outcomes is often negligible. However, there are cases where
the probability of future earnings going negative is not de minimis and has a significant impact on the
145 As described in Section 5.4.3, there is an exception related to diversifiable events. If the metric distribution is substantially lumpy or
asymmetric due to future diversifiable events (such as success of product development efforts), it is relatively straightforward to
incorporate the impact of the resolution of such events on the metric distribution into the modeling.
146 In contrast to equities, where the criticism is that the tails of the normal distribution are not wide enough, revenue and EBITDA might
tend to have narrower tails than a normal distribution due to real world constraints such as, for example, capacity (on the high end)
and already booked or repeat business (on the low end).
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value of the contingent consideration. In such cases, one can still maintain the normal distribution
assumption either by basing the model on pre-earnings financial metrics (such as revenues) or via the
use of more sophisticated techniques. These alternatives are described in more detail in Section 10.3.6.
While the application of the normal distribution to equity/asset returns has become widely accepted,
and the application of options theory to financial assets that are not traded in the market has been
around for more than 20 years (see Section 10.3.7), the use of a normal distribution to model growth
rates of underlying financial metrics is relatively new in the context of contingent consideration
valuation. At least some justification for the use of the normal distribution to model financial metrics
can be inferred from the correlation between movements in a company’s equity/asset value and its
financial metrics. However, similar to most applications in finance, the primary reasons for applying
the normal distribution assumption to financial metrics are ease of use and mathematical tractability.
In particular, the normal distribution assumption facilitates the use of a risk-neutral framework that
can easily incorporate the impact of the nonlinear payoff structure of an earnout into the valuation.
The normal distribution assumption is also the limiting case of a random walk and is generally justified
by the central limit theorem. As such, the normal distribution tends to be a natural and objectively
defensible model for financial metrics where there is no well-established alternative.
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10.3.6 Characteristics of a Geometric Brownian Motion, Extensions and Alternatives
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As discussed in Sections 5.4.3 and 10.3.5, when the characteristics of a GBM are substantially
deficient (or contradict) the distribution of the underling metric being modelled and this deficiency is
anticipated to have a significant impact on the value of the earnout, then a valuation specialist should
consider alternative models that resolve these deficiencies.
Below are some key characteristics of a GBM to consider when determining whether it is an
appropriate model. A GBM process St has the following properties:
• Growth rate of St is assumed to be normally distributed (i.e. Log (St/ St-1) ~ Normal)
o Alternative models with non-normal increments could be considered (for example, one
may be able to apply a more generalized Lévy process).
• St is always positive
o If there is a significant probability of the earnout metric going negative and this would
significantly impact the earnout payment, then the valuation specialist may want to
consider a model that allows the metric to go negative.
o For example, suppose EBITDA has a substantial probability of being negative in one year
and clawback payments are based on one-year EBITDA thresholds that are negative. Then
the valuation specialist could consider performing the entire analysis based on revenues
(converting thresholds, caps, tiers, etc. from EBITDA to a corresponding revenue amount).
Since revenues are typically not negative, the issue is circumvented.
o Alternatively, if conversion to revenues is problematic, the valuation specialist could
assume Arithmetic Brownian Motion (ABM) for the underlying metric. ABM allows the
underlying metric to go negative while still preserving the tractable properties of the normal
distribution assumption.
o Yet another option is to transform the distribution to a non-negative distribution in a
manner that is consistent with modeling in a risk-neutral framework, as discussed in Wang
(2002).
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• St is continuous with respect to time t (i.e. there are no “jumps”)
o If the distribution has jumps (is “lumpy”) due only to the uncertainty around a small
number of discrete events with diversifiable risk, such as outcomes of R&D programs, the
valuation specialist can often take such diversifiable events into account via defining
scenarios based on the outcomes of these diversifiable events, computing the payoffs in
those scenarios (which no longer have a “lumpy” distribution and so are appropriate for
the application of a GBM), and probability-weighting the payoffs in those scenarios.147
o If there are significant discrete drops or jumps in the metric distribution due to a non-
diversifiable risk, one may want to consider a model that allows for these “jumps” like a
jump diffusion model.
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• Correlation(St, St+k)
2
𝜎𝜎
𝑀𝑀
2
2
𝑀𝑀
𝜎𝜎
(𝑀𝑀+𝑀𝑀)
= �𝑒𝑒
− 1��𝑒𝑒
− 1� ��𝑒𝑒
�
𝜎𝜎
o Subsequent realizations of a GBM usually have a strong positive correlation (> 50%). This
characteristic is also generally true for subsequent financial metrics. However, if this
assumption is significantly deficient (e.g. if subsequent year’s financial metric is
anticipated to be negatively correlated with each prior year) and this has a significant
impact on the value of the earnout, then the valuation specialist may want to model each
period-specific underlying metric as a separate GBM, and apply a specific correlation
between the GBMs.
− 1�
• Volatility of St is a known constant (or a known deterministic function)
o Alternative models to GBM can assume that volatility has its own stochastic process, for
example, the Heston Model.148
Models such as Arithmetic Brownian Motion, a more generalized Lévy process, and the Heston Model
generally increase complexity and can introduce additional issues as compared to a GBM. These
models are less well understood and have been less frequently studied as compared to the widely
applied GBM. Since consideration should be given to the trade-off between computational complexity
versus a more accurate representation of the real-world metric distribution, the usage of these
alternative models should be rare.
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10.3.7 Academic Support for Use of OPM for Non-Traded Financial Metrics
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The academic support for the concepts presented in this Valuation Advisory starts with the literature
on option pricing theory. Examples of this vast literature that are referenced in this Valuation Advisory
include the 1973 papers “The Pricing of Options and Corporate Liabilities” by Black and Scholes and
the “Theory of Rational Option Pricing” by Merton, the 1979 Journal of Financial Economics article
“Option pricing: A Simplified Approach,” by Cox, Ross, and Rubinstein and the textbook Principles
of Corporate Finance by Brealey, Myers, and Allen.
More specific to the application of options theory to assets and liabilities that are not traded in the
market is the literature on real options. Textbooks on this topic were published starting in the 1990s.
Examples of textbooks on real options include Options, Futures, and Other Derivatives by Hull (first
published in 1995, see e.g., Chapter 34, “Real Options” in the 2011 edition), An Applied Course in
147 Similar modeling of such events should also be included in the valuation of the business, if the resolution of the uncertainty
significantly impacts the value of the business.
148 Heston (1993), “A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options.”
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Real Options by Shockley (2006), and Real Options: A Practitioner’s Guide by Copeland and
Antikarov (2001).
There is also a robust literature associated with the insurance industry on pricing risks, including the
pricing of contingent payoffs where the underlying asset or liability is not traded. See, for example,
“Modern Valuation Techniques” (Jarvis et al., 2001) and “A Universal Framework for Pricing
Financial and Insurance Risks” (Wang 2002).
The literature specific to valuing earnouts (as opposed to the more general literature on the application
of options theory to valuation of untraded assets/liabilities in general) was thin until recently. This was
part of the motivation for this Valuation Advisory. The literature includes a 2005 textbook by Arzac
entitled Valuations for Mergers, Buyouts, and Restructuring (see chapter 10.6 in this textbook,
“Earnouts as Options on Future Cash Flows”), a 2009 Business Valuation Review article by Tallau
entitled “The Value of Earn Out Clauses: an options based approach”149 and a 2012 European Journal
of Operation Research article by Lukas, Reuer and Welling entitled “Earnouts in merger and
acquisitions: a game theoretic option pricing approach.” Members of the Working Group and other
valuation professionals have also made numerous presentations on this topic at various conferences,
including conferences of the American Society of Appraisers and the American Institute of Certified
Public Accountants dating back at least to 2009.
The literature on estimating betas is extensive, and includes literature on asset betas, revenue betas,
issues relating to short vs. long-term betas, etc. Examples of the literature related to revenue betas
(which tends to be less well known than the literature on betas more generally) include the textbooks
by Hull (2011) and Brealey, Myers and Allen (2013), along with Cost of Capital by Pratt and
Grabowski (2014).
Lastly, we note that in general for business valuation, the models don’t change depending on whether
what’s being valued is a public (traded) or private (untraded) business. The same is true for options.
We therefore end this section by quoting Stewart Myers:150
“A misunderstanding you run into is the idea that it is somehow inappropriate to use option
pricing techniques in a corporate setting when you are dealing with non-traded assets. You
hear this again and again from very sophisticated people. And it reflects a misunderstanding
of what corporate finance is all about…”
10.4 References
American Bar Association. “Private Target Mergers & Acquisitions Deal Points Study (Including
Transactions from 2016 and H1 2017).” December 2017.
https://www.tagonline.org/files/2.-2017-ABA-MandA-Deal-Points-Study-Private-Target.pdf.
Arzac, Enrique R. Valuations for Mergers, Buyouts, and Restructuring. John Wiley & Sons, Inc.,
2005.
Bachelier, Louis. (1900). Théorie de la spéculation, Annales de l'Ecole Normale Supérieure, 17, 21-
86.
Black, Fisher and Myron Scholes. “The Pricing of Options and Corporate Liabilities.” The Journal of
Political Economy, vol. 81 (1973): 637-654.
149 The author uses an options methodology to value earnouts with financial metrics. This article does not, however, address the
RMRP.
150 Stewart Myers Keynote Address at the Symposium on Real Options, 2003, University of Maryland.
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Brealey, Richard A., Stewart C. Myers, and Franklin Allen. Principles of Corporate Finance. 11th ed.
McGraw-Hill/Irwin, 2013.
Copeland, Thomas E. and Vladimir Antikarov. Real Options, A Practitioner’s Guide. New York:
Texere, 2001.
Cox, John C., Stephen A. Ross, and Mark Rubinstein. “Option pricing: A Simplified Approach.”
Journal of Financial Economics, vol. 7 (1979): 229-263.
Fama, Eugene F. and Kenneth R. French. “A Five-Factor Asset Pricing Model.” CFA Digest, Vol. 45
No. 4, April 2015.
Grabowski, Roger J., James P. Harrington, and Carla Nunes. 2017 Valuation Handbook: U.S. Guide
to Cost of Capital. Duff & Phelps, 2017.
Grabowski, Roger J., James P. Harrington, and Carla Nunes. 2017 Valuation Handbook: International
Guide to Cost of Capital. Duff & Phelps, 2017.
Hamada, Robert S. “The Effect of the Firm’s Capital Structure on the Systematic Risk of Common
Stocks.” Journal of Finance, vol. 27 (1972): 435-452.
Herr, James K. “Size Adjustments for Stock Return Volatilities.” Business Valuation Review, Vol. 27,
No. 4. 2008.
Heston, Steven L. (1993). "A Closed-Form Solution for Options with Stochastic Volatility with
Applications to Bond and Currency Options". The Review of Financial Studies. 6 (2): 327–343.
Houlihan,
Lokey.
“2014
Purchase
Price Allocation
Study.” November
2015.
https://www.hl.com/us/insightsandideas/10737418425.aspx.
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Hull, John C. Options, Futures, and Other Derivatives. 8th ed. Prentice Hall, 2011.
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Jarvis, Stuart, Frances Southall and Elliot Varnell. “Modern Valuation Techniques.” Presentation to
the Staple Inn Actuarial Society, 2001.
Longstaff, F. A. and E. S. Schwartz. “Valuing American options by simulation: A simple least-squares
approach.” Review of Financial Studies, 14 (2001): 113–147.
Lukas, Elmar, Jeffery Reuer and Andreas Welling. “Earnouts in merger and acquisitions: a game
theoretic option pricing approach.” European Journal of Operation Research, Elsevier, 2012.
McKinsey & Company, Tim Koller, Marc Goedhart, and David Wessels. Valuation: Measuring and
Managing the Value of Companies, 5th ed. Wiley, 2010.
Merton, Robert C. “Theory of Rational Option Pricing.” The Bell Journal of Economics and
Management Science, vol. 4 (1973): 141-183.
Montibeller, Gilberto and Detlof von Winterfeldt. “Cognitive and Motivational Biases in Decision and
Risk Analysis.” Risk Analysis, Vol. 35, No. 7 (2015): 1230-1251.
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Pratt, Shannon P. and Roger J. Grabowski. Cost of Capital. 5th ed. Wiley, 2014.
4051
Shockley, Richard L. An Applied Course in Real Options. Thomson South-Western Finance, 2006.
4052
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Soll, Jack B., Katherine L. Milkman and John W. Payne. “Outsmart Your Own Biases.” Harvard
Business Review, Vol. 93, May 2015: 65-72.
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SRS Acquiom. “2018 M&A Deal Terms Study: Discussing an analysis of deal terms in private-target
M&A transactions that closed between 2014–2017.” May 2018.
https://www.srsacquiom.com/resources/2018-srs-acquiom-ma-deal-terms-study/.
Tallau, Christian. “The Value of Earn Out Clauses: An options based approach.” Business Valuation
Review, 2009, Volume 28 Number 4, American Society of Appraisers.
Tversky, Amos and Daniel Kahneman, “Judgement Under Uncertainty: Heuristics and Biases.”
Science, vol. 185 (1974): 1124-1131.
Wang, Shaun S. “A Universal Framework for Pricing Financial and Insurance Risks.” ASTIN
Bulletin: The Journal of the International Actuarial Association, vol. 32, issue 02 (2002): 213-
234.
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Valuation services
guidance
Introduction
This document sets out guidance, methodology and example documents for valuation services.
Introduction
Valuations involve reporting on, or advising on, business, company, share and asset valuations,
either for commercial or statutory purposes. Valuations assignments may be provided alongside a
number of service lines such as tax, forensic or recovery and reorganisation.
Valuation is a service line which is high risk due to the direct link between the results of our work
and the price a buyer or seller may pay or may receive, where there is reliance on our opinion. In
addition, most valuations are based on forecasts and specific assumptions about possible
developments in the future. The nature of valuation services assignments leads to a significant risk
of potential claims from clients and others who rely on our work and could suffer loss when, for
example, the value of a business does not prove to be properly derived. In such circumstances,
clients and shareholders may seek to apportion blame and obtain financial compensation for their
loss, regardless of whether or not we are at fault.
What are valuation services?
Introduction
1. Valuation services involve the act or process of developing an opinion of value. As such, it
is never a fact but always an opinion on the worth of the object to be valued at a given time
in accordance with a specific definition of value. This definition depends on the reason a
valuation is carried out and, on the methods employed.
2. Valuations not only differ in their application but also in the role a valuer is expected to play
in the valuation process. This role has significant impact on the manner in which the
valuation work should be performed.
3. There are two basic definitions of value, which are of varying importance depending on the
reason or the purpose of valuations:
4. The Fair (Market) Value reflects the price at which property would change hands between
a hypothetically willing and able buyer and a hypothetically willing and able seller. The Fair
Market Value can be seen as a general estimate of what a business would sell for in the
open market and is independent of a particular investor. It is assumed that both buyer and
seller have reasonable knowledge of the relevant facts
5. The Investment Value is the value of a business to a specific investor. It reflects individual
investment requirements and expectations such as synergies, tax issues specific to the
investor and policies the investor is likely to implement.
© 2018 Grant Thornton International Ltd. All rights reserved. Grant Thornton International Ltd (GTIL) and the
member firms are not a worldwide partnership. GTIL and each member firm is a separate legal entity. Services
are delivered independently by the member firms. GTIL does not provide services to clients. GTIL and its
member firms are not agents of, and do not obligate, one another and are not liable for one another’s acts or
omissions.
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1
Scope of valuation services
6. The term valuation services is limited to business valuation or the valuation of shares in a
business. Advice on the valuation of specific assets such as real estate, intellectual
property plant and machinery, or brands is not (yet) covered. However, the principles and
guidance in this document can also be applied to these assignments.
Reasons for valuation services assignments
7. The reasons for business valuations can broadly be divided into:
•
•
•
valuations made in accordance with statutory or legal requirements
accounting standards or contractual agreements
valuations carried out for other reasons.
Statutory or legal requirements
8. Valuations based on statutory or legal requirements can be fiscal and non-fiscal:
•
•
fiscal valuations result from provisions of tax regulations such as capital gains tax,
inheritance tax, income tax or corporation tax
non-fiscal requirements result from litigation support, determination of a fair compensation,
settlements made in the form of equity and shares or cash
Contractual agreements
9. Valuations on the basis of contractual agreements occur when partners join, leave or retire
from a partnership or a joint-venture and in cases of inheritance or divorce disputes or
settlements. They can also be required by call or put options of non-listed companies.
Accounting purposes
10. Valuation services may relate to accounting purposes eg the implementation of accounting
standards, in particular, those concerning accounting for business participations and
goodwill (eg SFAS 141, 142, IAS 36 and 38, IFRS 3). This may involve preparing a report
for a client or providing support to the audit practice.
Other reasons
11. Other reasons for valuations include:
•
•
•
acquisition and sale of a company or a part thereof
restructuring
fund raising
• mergers, demergers, takeovers
•
•
•
allocation of equity and debt capital
capital increase in return for stock (including the entire assets of a company)
initial public offering or delisting
• management buy-out
•
•
value-based management concepts
fairness opinions
© 2018 Grant Thornton International Ltd. All rights reserved. Grant Thornton International Ltd (GTIL) and the
member firms are not a worldwide partnership. GTIL and each member firm is a separate legal entity. Services
are delivered independently by the member firms. GTIL does not provide services to clients. GTIL and its
member firms are not agents of, and do not obligate, one another and are not liable for one another’s acts or
omissions.
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Role/function of a valuer
A valuer can perform a number of different roles depending on the nature of the business valuation,
most common roles are those of:
•
•
a neutral expert
an adviser
Neutral / independent expert
1. As a neutral or independent expert , the valuer is to take an objective view of the value of
the business. This view has to be based on a comprehensible methodology, independent
from involved parties' perceptions regarding the value. In other words, the valuer is to give
an opinion on the fair market value of the business.
Advisor
2. Valuation services assignments in an advisory function often rely on individually-tailored
assumptions related to the specific engagement. In the course of advising a client in the
purchase or sale of a company, business, asset or shareholding, or as part of an exercise
to raise equity or loan finance, we may be required to advise a client on a range of values
to seek or offer for the asset in question as part of the deal shaping or negotiation process.
We need to agree what plans are to be taken into account in our valuation, eg synergies
expected in an M&A transaction or new financing structures. This will depend on the
requirements of our client. In such assignments the valuation exercise may indicate a
range of possible values depending on our client and our role.
Conduct of valuations
Introduction
1. This section includes some specific matters to be considered for valuation assignments.
Ethics and commercial conflicts of interest
2. There are certain limits to independence when we are engaged as an advisor. Being
engaged as an advisor necessarily implies pursuing the client's interests, however, integrity
calls for a clear and comprehensive disclosure of our role as an advisor by putting our work
in perspective for any addressee of our report. Furthermore, objectivity of the valuation
approaches used are still a vital element of our work, limiting the range of possible
valuation results in an advisory context.
3. The lead partner should not run valuation assignments if historical aspects of any entity for
which he/she has already provided a statutory (or otherwise) audit opinion are of major
significance for the valuation. However, it is still acceptable for the lead partner to report
on a working capital or forecast review within a valuation process or lead a valuation
assignment if no independent judgement on the adequacy of past figures is required
throughout the process.
4. Before being engaged as a valuation expert by a client to which we also provide auditing
services, we need to ensure that laws, regulations or best practice customs actually allow
the performance of both kinds of services to the same client.
5. We should not accept instructions to act for both sides in disputes unless appointed jointly
by both sides in assignments that require us to work as arbitrator or mediator.
Furthermore, we should not act in a quasi-judicial capacity (eg as arbitrator) where we
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have previously advised one of the parties to the dispute on the matter which is subject of
the dispute.
6. Where we are engaged to report to more than one party, for example as independent
expert, we should not, and should not be perceived to, favour one party at the expense of
the other.
7. We may be considered to have a conflict if we have already carried out a valuation, for
example in the course advising on a transaction, and are then subsequently requested to
provide an independent formal valuation in accordance with the terms of a Shareholders'
Agreement.
8. Care should be taken regarding potential conflicts of interest in Valuation Services
assignments where:
•
the fee is contingent on the successful outcome of the transaction (especially relevant in
valuations provided in an M&A)
• where the basis for calculating the fee is a percentage of the transaction value (where this
amount itself is variable)
Principles of valuation
9. Fundamental principles that should be followed when conducting valuations are outlined
below.
Valuation purpose
10. Depending upon the business value to be determined, different assumptions are normally
made eg regarding forecasts and discounting future profits/cash flows of the business. The
accuracy of different sets of assumptions can differ with respect to the role we are to play
in a valuation. A proper assessment of the value of a business requires a proper definition
of the of the valuation purpose and should be set out in the engagement letter.
The valuation subject
11. Businesses are specific combinations of tangible and intangible items that are intended to
work jointly to produce business profits. The value of a business is, apart from specific
valuation contexts, not determined as the sum of individual items of assets and liabilities,
but rather by the combination of all items involved in the business.
12. The business to be valued naturally consists of assets required for the operations. In
addition, businesses sometimes own assets that are not required for operations called
'non-operating assets'. These should be valued separately.
Valuation date
13. Business values are determined at a particular point in time. A valuation date which is
contractually agreed or determined by statute clarifies what business profits may no longer
be considered in terms of income-based valuation approaches because they have already
been passed to the (former) owners of the business Additionally, expectations of the
parties interested in the valuation, both for future business profits of the business being
valued and of the optimum alternative investment, depend on the amount of information
available at a certain point in time. Where the date of the valuation and the time at which
the valuation is carried out are different, only information which could have been obtained
with due care at the valuation date can be considered. This is of particular importance in
cases where we are assigned as an arbitrator or a neutral expert to determine a company's
fair value at a point in time in the past.
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Valuations in transaction advisory services assignments
14. Sometimes we may be asked during or after completion of a transaction advisory services
assignment (eg a due diligence assignment) to provide valuation advice. If during or after
we have carried out our due diligence work, our clients ask for an opinion regarding the
impact of our work on the transaction value, we should decline to comment. Such
statements (either verbal or written) on valuation issues are not part of a normal due
diligence assignment and should therefore not be given as part of the Transaction Advisory
Services assignment. Without a separate engagement letter containing adequate
protection and without appropriate risk management procedures, there could be significant
financial exposure for us. If there are reasons for us to carry out valuation work, this
should be treated as a separate assignment and the appropriate procedures followed.
Indicative valuations
15. In practice, it is necessary to distinguish between indicative valuations and detailed
valuations. Being faced with a limited scope of time (and possibly also information)
indicative valuations that give a rough overview of a broad range of possible values can be
very useful eg when indicating whether a transaction is worth pursuing at all or if the
available budget is sufficient. A valuation expert should be involved in any valuation
project even if it is only intended to provide an indicative view on a business' value. The
client should be explicitly informed that a value has been derived by means of indicative
valuation and that a more detailed valuation approach could have led to different results.
Ideally, the engagement letter should already state that an indicative valuation usually does
not comply with all provisions of common valuation standards but instead results from
experience and less detailed and sophisticated calculations. If necessary, the engagement
letter should also point out that only a detailed valuation can provide a reliable result.
Engagement letter and scope of work
Engagement letter
16. An example engagement letter for valuations is available.
Scope of work
17. The engagement letter should clearly specify what is to be valued ie shares (which may be
100% of the issued share capital, a controlling interest or a minority interest), assets, the
business or the company itself (based on the equity value or enterprise value). We should
consider:
• whether there are any rights or obligations associated with the shares which may affect a
share-based valuation
•
an appropriate discount to apply to a minority shareholding.
18. The engagement letter should set out the purpose of the valuation and how the valuation is
to be used, as this will establish our duty of care.
19. The engagement letter should clearly establish for whom the valuation is being prepared
and to whom we are reporting as this will influence our approach to the valuation. The
engagement letter should make clear with whom we have a contractual relationship and
who is responsible for our fees.
20. The engagement letter should specify valuation report output (for example short form
report, long form report, letter).
21. The engagement letter should establish the basis of the valuation eg market value (which
may need to be agreed with the parties to the engagement).
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22. The engagement letter should specify the date at which the valuation is to be made, which
will determine the information we need to consider when performing the valuation.
23. The engagement letter should specify the information required for the relevant valuation
methods to be applied. It should also state, that the information requested may not prove
to be sufficient and additional requests for information and explanations may follow.
24. The engagement letter should state that the accuracy of the results of valuation
assignments relies on the data available. If we are aware that information will be restricted
this should be stated in the engagement letter making it clear that this will reduce the
reliability of the resulting valuation.
25. In cases where business combinations are valued, it is crucial to the scope of work whether
the individual companies are valued separately or as a whole.
26. As financial modelling is a vital part of valuation work, comments regarding the complexity
of modelling for the purpose of the valuation may be included in the scope of work.
27. The engagement letter should also emphasise that the value of non-operating assets has
to be determined if relevant.
Limited scope
28. In circumstances where we are engaged to provide an indicative valuation we may not be
able to cap our potential liability at a lower levels than for work involving a fuller scope and,
as a result, such assignments may be seen to represent a higher than normal risk.
29. A limited scope assignment could result in a significant matter being overlooked or not
discovered until after a transaction has completed. Even if the matter falls outside the
scope of our assignment, we could still find ourselves the subject of an opportunistic
negligence claim.
30. Clients should be forewarned of these risks at an early meeting to discuss the terms of the
engagement. In addition, it is important that the engagement letter includes an appropriate
reference to the fact that the scope of the investigation has been restricted in accordance
with the client's written instructions. Care should be taken when drafting the scope of work
to ensure that there are no ambiguous areas. In order to avoid any doubt it may be
necessary to set out work that we will not be undertaking..
31. We should always establish why the client is instructing us to undertake a limited scope
assignment. Very often, the client will be seeking to obtain the same degree of comfort as
a full scope valuation assignment, but for a reduced fee. In these circumstances, if the
client cannot be persuaded to increase the scope of work (and therefore the fee), we
should decline the assignment.
32. In summary, the engagement letter should clearly set out the limitations of an indicative
valuation.
File index
33. Example file indexes are available. Either may be used and edited to the circumstances of
the assignment.
Work programmes and checklists
34. A valuations work programme is available.
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Information for the valuation
Information request
35. An example information request list in both a short and long version is available. Either
version may be used and edited to the circumstances of the assignment.
Basic principles
36. Our terms of engagement do not usually require a verification of the accuracy of historical
audits or the detection of fraud but we should still assess the reliability and completeness
of the documents and information received to ensure our valuation work is soundly based
and to avoid exposure to claims due to damages arising from negligence.
37. In all valuation assignments where we act as an independent expert we should obtain a
signed letter of representation from the entity's representatives. This does not release us
from reaching our own conclusion as to the reliability of for example the forecast and
assumptions made.
Historical figures
38. Historical data used for valuation purposes should be based, where possible, on audited
financial statements. When the financial statements referred to are not audited, we should
consider whether the financial information used is reliable and present any findings in the
valuation report.
39. If we consider we cannot rely on the historical financial information, we may contact the
client to obtain additional information or determine whether the engagement letter should
be revised to include verification work and hence the additional cost of such work. Where
we cannot entirely rely on historical figures as presented by the client, any adjustments
made by us should be specified in the report. Reconciliations to figures presented by the
client should always be documented in our working papers.
40. Along with past financial statements, we may also be provided with historic figures in
management accounts or other internal formats. We should seek to reconcile figures from
management accounts to audited financial statements wherever possible.
41. Often, we may only be provided with drafts of the audited financial statements of the year
prior to the valuation date. Whenever final audited statements are expected to be
available, we should be certain that we receive them and consider them in our valuation
analysis.
Forecasts
42. Forecasts important input data to most valuations. It is essential to assess the
reasonableness of forecasts in order to achieve credible valuation results. Assessments of
forecasts is one of the highest risk areas of our valuation services assignments because:
•
•
•
forecasts reflect management's judgement, based on present circumstances and future
events, and may be affected by many unforeseeable and uncontrollable factors
the directors' assumptions can rarely be substantiated to the same degree as historical
information
clients and other users of forecasts frequently overestimate the reliance that can be placed
on our involvement.
43. Forecasts provided by the client should be compared with documented budgeting and
forecasting procedures of the client to ensure that we received the latest version. In case
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of doubt documentation and assumptions underlying the forecasts should also be carefully
assessed for reasonableness. We can never confirm that a forecast is accurate because
by its nature a forecast is a subjective assessment of events that have not occurred and so
cannot be an accurate representation of future results.
44. Minutes of board and supervisory board meetings or similar documents should be acquired
to prove that we have received the officially adopted versions.
45. In cases where DCF/earnings-based and Comparative Company approaches are applied,
it is extremely important that valuations are based on a realistic forecast results.
Therefore, if several scenarios exist, the most probable scenario needs to be selected as a
basis for our valuation work. If company forecasts are assessed as being either optimistic
or pessimistic we may need to consider modifying the forecasts to make them realistic. We
should inform our client if we do not consider the forecasts to be reasonable. If the client
nevertheless asks us to refer to unmodified forecasts in our valuation, we may need to
specify this in our report and to consider how we allow for this in our valuation analysis.
46. Forecasts are the responsibility of the company's directors not the Firm. If a company has
no regular financial planning system, as can be the case with small or medium-sized firms,
we may need to give the management some assistance in compiling a forecast. All
material input to the forecasts, especially expectations of future developments of sales,
costs, profitability and other fundamental financial aspects, need to be made by the
company's management. Furthermore, we should clearly state in our report the extent to
which we assisted with the compilation of the forecast and emphasise that we had no
influence on the selection of the basic assumptions underlying the figures.
47. Assessing the reasonableness of forecasts is a vital part of our work in the valuation
process. There are some basic steps in this process that need to be noted.
48. Mathematical accuracy and internal consistency of forecasts should be reviewed as
calculation errors, if undetected, can have a major impact on the business value.
49. Key financial ratios (eg growth rates of revenues and cost, margin, meaningful ratios
between revenue and cost figures) should be calculated and should then be tested against
third party data such as market surveys and financial data of competitors if available.
50. Management should be interviewed about the reasonableness of their forecasts. Only in
exceptional cases can we justify not discussing forecasts with management.
51. The valuation work programme sets out the minimum procedures to be followed when
reviewing forecasts in the context of valuation services. It also gives some further
assistance with how to proceed with assessing the reasonableness of forecasts in the
valuation process.
Other (legal) documents
52. The reliability and completeness of other and specifically legally binding documents should
be considered in terms of:
authorisation of signature(s)
completeness of authorised signatures in cases where more than one signature is required
to legitimise a document
adherence to formal requirements (eg as recorded by a notary)
completeness of referenced exhibits
•
•
•
•
53. Whenever there is doubt about copies of legal documents, we should consider whether
original copies should be provided
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member firms are not a worldwide partnership. GTIL and each member firm is a separate legal entity. Services
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Reporting
Length of report
54. Reports that are to be made publicly available are usually less extensive so as not to give
too much away to competitors. Reports on litigation support assignments and contractual
agreements tend to be rather lengthy, because valuation methods as well as specific
aspects of the individual case have to be explained in detail in to be understood or
admissible in court.
55. Valuation reports can sometimes be very short, particularly in cases referring to fairness
opinions. Fairness opinions are usually required in the context of mergers and acquisitions
and state whether a value is appraised to be fair by a neutral expert. Fairness opinions (eg
those addressed to the management board) are often written in letter format.
56. It may be useful to present valuation results by means of a memorandum when an
assignment has a limited scope of required valuation work that indicates a restricted depth
of analysis due to a limited scope of time or restricted access to data. If the restricted
access or availability of data and information concerning a business to be valued is
perceived from the outset, we should agree upon a memorandum form of reporting in the
engagement letter to our client that corresponds to the extent of our work.
57. Regardless of report presentation, the same level of background analysis, which can be
limited in terms of accessible information, should be completed prior to deriving the value
of a business. It is particularly important for the client to understand that the fees of our
engagement are not exclusively tied to the number of printed pages within the report.
Principles of reporting
58. The main aim of the valuation report is to set out a clear value or range of values for the
business and to explain them. The valuation report becomes meaningless if the range of
values is too wide.
59. The valuation report should describe the role of the valuer within the valuation process and
set out the principles being applied. Reference should be made to whether the value is
independent from the parties involved or advisory in terms of supporting the client's
decision-making process or arrived at through arbitration process.
60. There should be an adequate description of the procedures carried out for the business
valuation. In this context, the valuation method(s) used and the reason for their selection in
the specific situation should be explained. As valuations of businesses are usually based
on several assumptions that have considerable influence on the valuation, the valuer
should clearly state the significant assumptions underlying the value in the valuation report.
The scope of underlying data, the extent of estimates and assumptions should also be
detailed. We may also need to comment on the quality of the data. It should also be
clearly indicated whether the assumptions have been made by the valuer, the management
or by third parties.
Report content
61. The content and the scope of a report will vary from assignment to assignment. The report
should be laid out in an orderly and logical manner. In any valuation assignment, the
report should be tailored to reflect the consideration of following issues:
•
•
•
description/terms of the valuation engagement:
name of client(s)
valuation date
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member firms are not a worldwide partnership. GTIL and each member firm is a separate legal entity. Services
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•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
engagement (reason for valuation, our role as the valuer, client instructions)
sources and basis of information used
reference to statutory requirements and professional standards
restrictions on the scope of work (eg due to limited access or reliability of information)
limitation of liability
description of the nature of the business being valued (ie legal, financial and fiscal
background)
description of valuation principles and methods
description of valuation methods in general and applicability in particular case
description of valuation assumptions (especially concerning discount rates) and procedures
analysis of the information underlying the valuation
availability and quality of underlying data
analysis of historical financial data
reasonableness check/review of budget/forecast
description of valuation and presentation of results for the operating business
description of valuation and presentation of results for non-operating assets and/or special
values (eg from tax-loss carry forwards, disposal of assets)
summary/conclusion
appendices
62. A report template is available, which is designed for use in valuations where we act as an
adviser rather than an independent expert.
63. A purchase price allocation report template is also available.
Oral reporting
64. We should avoid giving oral opinions on valuation before we have performed the work
required for the valuation.
65. There may be situations, for example in meetings when advising clients in the negotiation
of a transaction, where we are required to express an informal view on valuation. In such
situations, we should avoid giving informal views on value as these may be interpreted as
formal advice. If such advice has to be provided, we should limit our advice by stating
clearly that it is based on incomplete information and should not be relied upon. We should
only indicate a wide range of potential values and follow up the meeting by documenting
the advice given so that our advice and disclaimers are clearly recorded.
66. Otherwise, we should only express a view on valuation once we have performed our work
in accordance in accordance with our procedures, having documented our conclusions in
our working papers.
Time lag between original valuation and third-party request for report
67. Be aware that the original valuation refers to a specific valuation date. In cases where
there is a significant time lag between the original valuation and any third-party request for
our report, it should be noted that the business's value refers to a specific valuation date.
Changes in the market place, changes concerning the financial performance of the
business to be valued or capital markets can affect the value of the business as stated in
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member firms are not a worldwide partnership. GTIL and each member firm is a separate legal entity. Services
are delivered independently by the member firms. GTIL does not provide services to clients. GTIL and its
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the original report. It is imperative that if the new party involved wishes to rely on our work
as at a current point in time, it is treated as a new engagement. A separate engagement
letter should be agreed with the third party and a supplementary fee charged for our
additional work.
Valuation memorandum
68. For every valuation assignment we should prepare a comprehensive written memorandum
for our working papers which should be reviewed by both the assignment partner and the
review partner before the valuation is communicated to the client. If we have prepared a
detailed valuation report the valuation memorandum may not be required.
69. The valuation memorandum should include:
•
•
•
•
•
the purpose of the valuation
a summary of the information used
the valuation methodology used
the reasoning behind the choice of methodology
our conclusions regarding valuation.
70. An example valuation memorandum is available.
Valuation methods
Overview
1. There are a number of possible methods to calculate the value of a business. The
generally accepted valuation methods will differ between countries, the nature of the target
entity and the type of transaction.
2. The section below sets out a summary of major valuation methodologies.
3. Valuations are required for a number of different purposes and the techniques used will
depend on the type of valuation required. Valuing a business is not an exact science as it
takes into account a significant degree of subjective judgements irrespective of the
apparent mathematical precision of most valuation approaches.
4. No single valuation method is appropriate to every circumstance. When performing a
valuation, it is important to remember that we are providing an opinion and not a statement
of fact and we cannot rely on any one valuation method in isolation. We should be aware
of the following commonly used valuation methodologies and consider an appropriate
selection of techniques when performing a valuation, choosing one or a combination of
methods appropriate to the specific valuation.
5.
In general, there are three main approaches and other methods used to value a business:
•
•
•
the market approach (market-based valuation)
the income approach (cash-flow/earning-based valuation)
asset-based (cost) approach
6. Further methods include:
•
real option-based valuation
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•
•
dividend yield
'rule-of-thumb'-based valuations
Market-based valuation
7. Public markets are generally considered information-efficient in valuing companies. Prices
of stocks, ie the Stock Exchange Value, which are traded in a free and active market by
informed persons can be assumed to be the best evidence on the fair value and can, when
available, be used as a basis for the measurement. Prices available for equity shares in
the entity listed on a stock exchange should be used in carrying out valuations of the entity
at least as a reasonableness evaluation of the other approaches if not as the primary
source of information about the entity's fair value. Certain factors such as trading volume
and liquidity should also be carefully analysed (and described) as they can have a major
impact on the quality of stock prices as an indicator of a business' fair value.
8. Substantial variances between the earnings-based value and the stock exchange value
which are not factually justifiable should be taken as a reason for critically examining the
data and assumptions upon which the valuation was based (eg a different view of the entity
taken by the market). In most valuations, the use of prices quoted on the stock exchange
cannot entirely or even partly replace the valuation of the company using the other
methods. In our role as a valuer, we can normally use internal information and forecast
considerations which would not be freely available on the market. The stock price is also
subject to influences not depending on the value, eg political and psychological factors
which often lead to considerable short-term fluctuation in price without having an effect on
the long-term change in the value of a business. Therefore, a stock price should always be
tested against other valuation approaches before it is viewed as being the best
measurement for a business' fair value.
9. Market-based valuation also includes the Comparative Company Approach, which aims to
identify suitable comparable companies to provide market value benchmarks. There are
different approaches, such as Comparative Publicly Listed Companies, Comparative Initial
Public Offerings, and Comparative Recent Transactions. All methods refer to realised
market values of companies similar to the fair value of the entity being valued. They
involve selecting a group of companies representative of the company that is to be valued.
Each comparable company's financial or operating data (such as sales, earnings, cash-
flows, number of customers, tons of production etc.) is then related to each company's total
market capitalisation to obtain one (or more) valuation multiples. A company's value is
derived by applying the (sometimes weighted) averages of these multiples to its relevant
data.
10. Depending on the specific multiple, attention should be paid to whether its application leads
to the market value in terms of the enterprise/equity value or the value of goodwill. In the
latter case, an additional valuation of the net assets is required in order to derive the value
of the business as a whole. It must be noted whether the applied multiple reflects the
market value of a business including its debt (enterprise value) or just the equity's market
value. The latter occurs if the multiple refers to a (financial) basis after interest payments.
11. The applicability of the Comparative Company Approach depends on the data available on
suitable comparable companies. Apart from listed companies, access to such data can be
limited, particularly for small and medium-sized companies and when finding comparable
companies, it is not a question of quantity, but quality. If one perfectly comparable
company has been identified, this would be more than sufficient to determine an
acceptable multiple as a range of reasonably comparable companies. Furthermore, as the
Comparative Company Approach usually reveals fairly broad ranges of market prices, it
should be seen as an instrument for indicative rather than detailed robust business
valuations.
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Capitalised earnings
12. A common market based approach is the application of a price/earnings multiple to the
maintainable earnings of the business.
13. This method is commonly used for the valuation of the equity value or enterprise value of a
company or business. It is, effectively, a simplification of the DCF method below, which
may be more suitable when income streams are complex or unstable.
Cash flow / earning-based valuation
14. Cash-flow based valuations measure the intrinsic worth of an asset, for example a
shareholding, on the basis of the future discounted operating cash flows (before the cost of
debt finance but after tax) generated by the asset.
15. This method requires the production of detailed cash flow forecasts and assumptions for at
least a five-year period. It is commonly used in support of an economic value/intrinsic
worth basis of valuation, and also where cash flows fluctuate widely. It can also be applied
in turnaround situations.
16. The cash-flow based valuation approach assumes that the value of a business is based on
its anticipated future earnings. From the business owner's point of view, the value of the
business is primarily based on their ability to achieve business profits. The most common
techniques used for income-based valuation are Discounted Cash Flow (DCF) methods.
These techniques are commonly used and are described in more detail later.
Asset-based valuation
17. Asset based valuations involve an assessment of the current market value of an asset or
the net assets of a business including the intangible assets. This method is commonly
used where losses are being incurred or the going concern value appears to be less than
the value recoverable on the liquidation of the business. This method is also appropriate
for certain types of businesses including property companies or investment companies.
18. It may be appropriate to use third parties for specialist valuations of specific tangible assets
such as plant or property or intangible assets such as brands.
19. The following are examples of asset based valuations:
20. Liquidation (or break-up) Value: liquidation proves to be economically advantageous
compared to going-concern when dealing with a company that has a poor cash-
flow/earnings-performance combined with a strong asset-basis
21. Reconstruction (or re-establishment) Value / Net Asset Value: due to certain circumstances
(eg regulation), a company may be obliged to provide certain services irrespective of their
profitability. Alternatively, a company's main economic purpose may be to increase its
asset values by not fully reflecting these increases in its earnings or cash-flow statements
(eg real estate companies or pure financial holdings).
Dividend yield
22. This method is commonly used for the valuation of a non-strategic minority shareholding
where the minority shareholders do not influence the company or its dividend policy.
Real option-based valuation
23. Real option-based valuation is a fairly new approach. The core concept of the approach is
to view a business as a bundle of options to invest in real assets. These options can be
exercised at their 'expiring date' (or before, depending on the type of option) if it appears
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advantageous to a company's management. Techniques for pricing financial options are
applied to the valuation of these real options in order to arrive at a business' fair value.
24. The practical application of the real option approach differs greatly in various countries.
While it is widely accepted within the US, other countries do not yet apply this method to
the valuation of companies. The latter is particularly due to the method's extensive
information requirements and limited acceptance both by practitioners and addressees of
valuations in these countries. The real option-based valuation is not explained in further
detail.
'Rule of thumb'-based valuation methods
25. 'Rule-of-thumb' based valuations usually refer to multiples that are used in particular
industries and are a means of determining simplified price. These rule-of-thumb valuations
can be a useful basis for reasonableness checks of our valuations. This is particularly
relevant for valuations carried out in the context of a transaction. Due to their very
indicative character, rules-of-thumb valuations should not be viewed as a substitute for any
of the other valuation approaches described above.
26. As they are based on multiples, rule-of-thumb valuations are technically quite similar to
valuations following the Comparative Company Approach. Contrary to this approach, the
valuer does not require information on past transactions or stock prices, but simply needs
to know the range of multipliers common to the concerned industry.
Discounted cash flow method (dcf)
27. DCF methods determine the valuation of a business by discounting projected future cash
flows at an appropriate discount rate. The cash flows represent expected (potential)
payments to the providers of capital. The definition of cash flow differs depending on the
procedure used to determine the market value of the equity of a business. The equity
market value can be determined indirectly by means of the entity approach or directly by
applying the equity approach as described below. Regardless of the method used, the
individual DCF techniques result in the same values as long as they are based on a
consistent set of assumptions.
Entity approach
28. The market value of equity is determined indirectly as the difference between the
enterprise and market value of the debt. The enterprise value equals the sum of the
market value of projected future cash flows to the owners of equity and debt. There are
different concepts based upon the entity approach. The weighted average cost of the
capital method (WACC) is the most commonly applied concept and is set out in more detail
below. Other entity approaches are the Adjusted Present Value approach (APV) and the
Total Cash-Flow approach (TCF). Due to their minor importance in common valuation
practice, these concepts are introduced only briefly.
Equity approach
29. The equity approach determines the market value of equity by discounting cash flows net
of cost of debt using the return on equity (cost of equity). Unlike the entity approach, the
approach results in the market value of equity.
Weighted average cost of capital (WACC)
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General procedure
30. Enterprise value using WACC is calculated by discounting future operating cash flows
(before interest but after corporation tax and capital expenditure). These can be estimated
as a constant, sustainable cash flow. Alternatively, the estimation can be divided into
phases. In the initial phase, cash flows can be forecasted in detail by referring to a
company's regular financial forecasts. In the second phase, cash flows are estimated as a
constant annual cash flow assumed to be sustainable throughout perpetuity (after the
period of detailed forecast). Occasionally, a third phase is introduced between the phase
of detailed forecast and the perpetual phase in order to map a period of cash flows higher
than perpetual growth. The following descriptions focus on the two-phase model.
31. Overall, the period of detailed forecast depends on aspects such as the business cycle of a
company, the stability of a company's earnings and its growth prospects. As a general
rule, it should be a five year forecast period, as this takes into consideration issues such as
purchase price accounting (IFRS 3, IAS 36/38). Nevertheless, the forecast period should
cover at least a full business cycle of the company.
32. In the first step, cash flows are discounted by an appropriate discount rate that reflects both
the time value of money and the inherent risk of equity and debt holdings. The discount
rate is derived by the WACC concept (for details see below).
33. In the second step, the value of assets not used in the business are then added to arrive at
the overall business value (enterprise value).
34. In the third step, this enterprise value is divided between equity and debt. In order to
obtain the market value of debt, the most accurate way from a financial theory standpoint is
to discount the cash flows to providers of debt using an interest rate which reflects the
(current) market cost of debt. In most cases however, the book value of debt is an
appropriate approximation for its current market value. Only in cases of long-term
borrowing based on fixed interest conditions that deviate significantly from current market
levels does a separate calculation of the debt's market value need to be considered.
35. The difference between enterprise value and market value of debt then represents the
market value of equity.
Determination of future operating cash flows
36. Future operating cash flows are those business cash streams that are available to all
providers of capital (debt and equity) after considering potential restrictions on distribution
under applicable company law and the impact of taxes. The cash flows represent business
profits after capital expenditure and corporation taxes but before any debt financing. In
determining cash flows, the ability of the entity to distribute business profits is reflected by
including changes in liquid funds and/or debts. Cash flows can be determined using the
indirect method.
37. The addition of interest on third-party debt can include interest due to explicit loan
agreements as well as implicit interest rates (particularly for pension obligations). The
latter assumes that the pension obligations are viewed as part of third-party debt and the
related cost of this debt is included in part of the weighted average cost of capital.
However, it is more common not to add implicit interest payments to cash flows. In this
case, pension obligations (or other triggers of implicit interest payments) need not be
subtracted from the enterprise value.
38. Taxes paid by the entity are to be deducted in determining cash-flows. They are
determined under the assumption that when no interest is paid, the tax shield arising from
deduction of interest on third-party debt is to be deducted from the cost of debt as part of
the WACC.
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Determination of residual or terminal value
39. Residual value is determined when the business is a going concern or being disposed.
Unless there are legal or economic reasons for not assuming either going concern or
liquidation, the higher value is to be used. The residual value can often represent well over
half or more than two thirds of the net present value of future cash flows. Great care
should therefore be taken in its calculation, particularly with regard to the composition of
the cash flows in the terminal year.
40. Assuming the business is a going concern, the residual value is the present value of cash
flows after the end of the detailed forecast period, which is commonly derived by use of a
perpetuity formula (described later). Weighted average cost of capital is usually assumed
to be constant for this period.
41. If it is assumed that the business will be sold, the expected sales value of the business less
any selling costs, is to be used.
Determination of cost of capital
42. The weighted average cost of capital depends on the cost of equity and debt and on the
ratio of debt and equity (based on market values). The weighted average cost of capital is
to be adjusted if it is expected that the ratio of debt to equity will change in the future.
Adjustments are also to be made for any likely future changes in the cost of equity and/or
cost of debt.
43. The cost of debt is calculated as the weighted average cost of all relevant forms of debt.
When the various components of debt are not explicitly interest bearing (particularly
pensions provisions), a market interest rate for equivalent debt is to be used (if it is decided
to consider them explicitly at all). Taxation borne by the business (corporation taxes) is to
be deducted in order to account for the tax savings stemming from debt financing.
44. For determination of cost of equity, the capital asset pricing model (CAPM) is currently the
most widely used method, although other approaches do exist. CAPM is based on a
financial portfolio theory framework enabling the derivation of cost of equity from objective
financial market data. CAPM states that the opportunity cost of equity corresponds to the
return on a risk-free investment plus a risk-related premium:
•
•
The risk-free return yields on governmental bonds are usually taken as a reasonable
approximation. Both current and historical yields or a weighted average of both can be an
adequate basis for the estimation of the risk-free return.
The risk-related premium is derived from multiplying the additional return of the market
over risk-free investments by the systematic risk, represented by the Beta-factor.
45. The relationship between the expected return of a security and its systematic risk is
described by the CAPM:
Expected return on equity of i
Risk-free interest rate
Expected market return
Premium return of the market
Systematic risk of the security i (Beta-factor)
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()()FMFiRRERRE−+=i()iREFR()MRE()FMRRE−i
46. According to the CAPM equation, the cost of equity increases in proportion to systematic
risk, which cannot be reduced by diversification. All elements of the CAPM are, in
principal, expected values derived from the observation of capital markets. In practice,
however, the determination of the risk premium is often based on past rather than future
returns of a market portfolio and a stock as future returns are difficult to reliably predict.
47. In past periods, beta values for those stocks listed on the stock exchange are available
through financial sources such as Bloomberg, Reuters or occasionally the financial press.
If a company is not listed on the stock exchange, beta factors need to be determined by
calculating an average beta factor of a peer group of companies active in the same or at
least comparable field of business. In this case, subjective judgement has a relatively
strong impact on the beta value as no clear-cut, strictly objective criteria exist on how to
compile a peer group. It should be noted that even the calculation of the beta factor of a
listed company is subject to a certain degree of subjectivity due to different modes of
calculation (eg different relative indices, different periods of time for calculation, etc).
48. More guidance on discount rates is included later.
Adjusted present value concept (APV)
49. The concept of APV divides total enterprise value into its component parts. Initially, it is
assumed that the business is entirely financed by equity and thus the market value of a
debt-free entity is determined. Thereafter, the contribution to value provided by debt is
calculated. The total of the market value of the debt-free equity and the value contribution
of debt (value of tax shield) equals the overall enterprise value which, after deduction of the
market value of debt, results in the business value of the equity. In practice, this method
proves particularly helpful for companies with a changing and apparently volatile capital
structure.
Total cash flow concept (TCF)
50. The TCF concept is very similar to the WACC. The main differences are the treatment of
the tax shield arising from the level of debt of a business. Unlike the WACC, where the tax
shield is part of the weighted average cost of capital, the TCF concept accounts for the tax
shield by adding it to the cash flow. Consequently, cost of debt as part of WACC is not
reduced by the corporate tax rate in order to avoid double counting of tax advantages from
debt financing.
Equity concept
51. The direct concept of the equity value is derived by discounting cash flows to the owner of
the equity by using the cost of equity (of an entity with debt) as the appropriate discount
rate. Thus, the net cash flows are reduced by payments made to the providers of debt.
The cost of equity reflects both the operational risk of the business and the financing risks
arising from the entity-specific capital structure.
52. When using the DCF method, it should be noted that the equity approach corresponds to
the procedures of the Capitalised Earnings method or Discounted Dividend method,
representing common valuation practice in some countries such as Germany.
Furthermore, in the case of valuations of banks and insurance companies, only the equity
concept is applicable among the various DCF approaches due to the specific financing
structures of such businesses making it difficult or impossible to identify cash flows to debt
owners. This also applies to valuations of some long-term order-driven businesses such
as transportation equipment manufacturing or shipbuilding, where companies are usually
financed through upfront customer payments as a form of interest-free debt-financing.
53. However, both entity and equity approaches rely on the same conceptual framework
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(present value calculation) and determine the value of a business by discounting projected
business profits. They differ only in terms of the definition of respective earnings cash
flows. Consequently, where valuation assumptions or simplifications are identical,
particularly with respect to financing, both methods will lead to the same entity value.
Re-establishment value / net asset value (NAV)
54. An NAV is based on the market or replacement value of net operating assets. The NAV is
the replacement value of, in principal, all existing intangible and tangible assets and
liabilities used in the business. To this extent, it reflects cash outflows already incurred that
can be saved by not having to establish an identical entity.
55. Market values of assets can deviate significantly from their book values. Book values need
to be replaced by market values if the latter can be determined separately, or book values
need to be adjusted by possibly existing hidden reserves or hidden losses. Hidden
reserves or losses can result from differences between the economic lifetime of an asset
and the lifetime assumed for accounting or tax purposes. They can also result from high
volatility of market prices not entirely tracked by changes in book values.
56. Due to the practical difficulties in determining assets not included on a balance sheet,
particularly intangible assets (eg intellectual property, established clients), a net asset
value is normally calculated as a net partial replacement value. This issue is less important
than the required disclosure of such intangible assets by means of purchase price
accounting. The net asset value, being a partial replacement value, does not have a direct
relationship to future business profits.
Liquidation value
57. Liquidation value is based on the present value of net revenues which arise from selling a
company's assets less its liabilities and liquidation costs. A deduction from income taxes
may also be required. Alternatively, when limited liability companies are liquidated, tax
recoveries on part of the equity already subject to corporation tax can increase the value.
58. When determining revenues from liquidation-induced sales of assets, certain aspects need
to be addressed. For example, difficulties in selling all assets at once need to be taken into
account by assuming either a longer sell-off period or a discount. Furthermore, assets can
be highly specific to a particular company resulting in a large difference between an asset's
book or replacement value and its value in a liquidation context. Hidden reserves can also
lead to liquidation values exceeding book values.
59. Liquidation costs can include redundancy program costs, disposal costs of machinery and
cancellation-costs of long-term contracts. They can also consist of costs for the elimination
of environmental damages.
Selection of adequate valuation methods
Introduction
1. The following section sets out issues that should be noted when selecting valuation
approaches for a particular assignment.
Valuers' role and reason for the valuation
2. The role of valuer in the valuation process has a major impact on the selection of adequate
valuation methods. If we are expected to act as an independent expert, it is essential that
we rely on valuation approaches that limit the degree of subjectivity of our work as much as
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possible. As an independent expert, it is crucial to be able to explain the valuation
approach in detail at any time, therefore documentation is very important. Consequently,
approaches that do not allow meaningful documentation such as rule-of-thumb approaches
may not be appropriate. In situations requiring an independent valuer, the valuation's legal
framework determines the selection of valuation methods as laws or legal practice may
accept only certain approaches as appropriate.
3. As an advisor, objectivity and documentation are usually not as important. It is instead
important to determine a realistic value as close as possible to the market's perception of a
business' value. We often face tight time schedules in an advisory context, therefore, it is
important to select methods that are commonly used in the relevant market place and allow
for an assessment of a realistic range of fair values within a limited period of time. Market-
based approaches, especially comparative company approaches, usually play a significant
role in a valuation for advisory purposes. However, as these methods may not fully reflect
the specific situation of the entity to be valued, they should, where possible, be tested
against DCF/Income-based approaches in order to obtain a more comprehensive picture of
the value of a business.
4. Occasionally, the reason for a valuation defines the possible valuation methods to be
selected. When valuing a business as an arbitrator for example, the methods applied are
quite often defined in purchase agreements or other relevant contracts. Therefore, when
selecting the appropriate valuation methods, it is very important to analyse the legal and
contractual framework as well as the client's intentions and needs in order to identify the
range of applicable methodologies.
Characteristics of the business to be valued
5. Specific features of the business to be valued can also have major impact on the selection
of valuation methods. In the case of a low-margin business with a strong asset basis,
liquidation value may exceed DCF/Income-based values. If a company's main focus is on
the improvement of the value of its assets, with those improvements not fully reflected in its
profit and loss-account, the Net Asset Value approach may lead to a more appropriate
business value than DCF/Income-based valuations. The Net Asset Value approach may
also be preferable in cases where company owners are obliged to provide the company's
services through laws and regulations even if the services is not profitable.
6. Within particular industries, there exist certain customs about how to value a company.
Those 'common-knowledge' approaches should be taken into account in a valuation
process. In an advisory context, they may even be used as the main indicator for the fair
value of a business.
7. The above examples illustrate the importance of analysing and identifying the
characteristics of a business before valuation methods are selected. Even in cases where
the appropriate methodology is strictly defined by the legal or contractual framework of the
valuation process, characteristics of a business can still suggest alternative valuation
methods in order to test the reasonableness of the results.
Multiple valuation methods
8. Due to the fact that valuation is not an exact science, different valuation methods can lead
to a range of business values. Depending on the purpose of the valuation and our role, it
may be appropriate to communicate a range of value or just a single business value. This
is particularly the case in situations where a definite value is required, for example when a
fair compensation has to be determined, and the communication of a range is not an
option. In this instance, the value resulting from the most appropriate valuation method
should be communicated.
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9. Even in these situations, it may be helpful to apply alternative approaches in order to test
the reasonableness of our results. As a general guideline we should, whenever possible
within our time and information restrictions, rely on different valuation approaches in order
to test our own valuation results.
Other practical issues
Valuation of non-operating assets
1. An entity often has assets that are not used in the business. Such non-operating assets
can be separately disposed of without affecting the normal activities of the business.
2. When valuing the entire business using DCF/Earnings-based methods, those assets not
required in the business, including any related liabilities, are subject to separate valuation
based on the best disposal value. When the break-up value of these assets exceeds the
present value of profits generated through these assets if they were to remain in the
business, a break-up scenario should be adopted.
3. When valuing non-operating assets at their break-up value, the cost of liquidation is to be
deducted as well as any tax effects at entity (and possibly shareholder) level. Where an
immediate liquidation cannot be expected, a liquidation plan must be drawn up and future
liquidation receipts must be discounted to the valuation date.
4.
If there are liabilities directly associated with the non-operating assets, the amounts
required to repay them must be deducted from the gross liquidation receipts, together with
any expenses related to their settlement.
5.
If assets which serve as collateral for loans are identified as non-operating assets, it should
be noted that their disposal could adversely affect the financing of a business.
6. When separately valuating the non-operating assets of a business, forecasts and business
plans may have to be adjusted by the effects on income and expenses arising from non-
operating assets.
Determination of adequate discount rates
(relevant for DCF/Earnings-based approaches only)
Introduction
7. Broadly speaking, methods for determining the different components of the discount rate
should be clear enough to enable any informed person to understand our methods and
results. Outlined earlier are some suggestions how to best derive the basic components of
the cost of equity as needed both in the DCF entity and Equity approach. These
suggestions give some indication on to proceed, but there are alternative methods that can
be applied.
8. When determining the cost of equity, the perspective of the valuer has to be carefully
considered. Depending on the home country of the valuer, this may lead to deviations in
calculating the different components of the cost of equity in different countries (most
notably related to different tax systems and levels of interest rates).
9. When calculating the cost of equity using CAPM, it should be noted that the cost of equity
(the opportunity cost of an alternative investment) has to be comparable to the business to
be valued in terms of maturity and risk profile.
10. In CAPM, the cost of equity is constructed by the return on a risk-free investment plus a
risk-related premium. While yields on government bonds are usually taken as an
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approximation for the risk-free rate, the risk premium is based on the additional return of
the market over risk-free investments times the systematic risk as represented by the Beta-
factor.
11. The role we take on in a valuation may also impact on the determination of the discount
rate. When considered in an advisory valuation assignment, the discount rate could
actually be based on the individual situation of an investor eg it may reflect the specific
expected return of the investor for an alternative investment, the interest rate required to
repay planned debt or an interest rate which is based on a subjective estimate of its
components (eg risk-uplift). The following practical advice is common professional practice
for valuation assignment where we act as a neutral / independent expert.
Risk-free rate of return
12. The risk-free rate of return is commonly based on the expected future returns of fixed
interest securities issued by local authorities (government bonds). Regarding the unlimited
life-span of the business to be valued, the expected long-term rate of return of government
bonds has to be taken into consideration.
13. When deriving the expected long-term yield of government bonds, you need to be aware
that the level of current interest rates is influenced by the economic cycle and thus could be
in a periodic low, a periodic high or somewhere in between. Current interest rates
representing a periodic high or low cannot necessarily be used as expected long-term rates
for discounting purposes as they may not reflect the long-term yield on government bonds.
14. The expected long-term rate of government bonds can be deduced by observing historic
and current yields. The historical average return on long-term government bonds in
circulation in recent decades is a good starting point. Such information can usually be
found in general publications of local regulatory institutions or of governmental authorities.
We need to consider current yields on long-term government securities and appraise
general economic circumstances which may indicate a periodic low or high of interest
rates. Current yields are available in the aforementioned publications or from financial
sources such as Bloomberg or Reuters. Finally, we need to balance the historic and
current returns of government bonds by finding an average long-term return rate which
represents the future estimate of the long-term average on government bonds and is
therefore an appropriate approximation of the risk-free rate of return.
15. An example of one possible way of calculating a risk-free rate of return is based on current
market yields up to a maturity of 30 years and the long-term average of historic average
yields for maturities beyond. An example valuation model is shown below:
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16. Alternatively, there are statistical models used for projecting the term structure of interest
rates beyond outstanding maturities. These estimates for the future development of the
term structure of interest rates can also be used to derive the expected long-term yield of
government bonds.
17. Investment banks prefer to apply current interest rates of government bonds with maturities
of 10 years or even shorter. From a valuation point of view, this course of action does not
comply with the valuation assumption that the business to be valued has an unlimited life-
span. The maturity of the risk-free rate used for discounting purposes should be equivalent
to the life-span of the business.
Market risk premium
18. The market risk premium is derived by deducting the return on risk-free investments from
the return on investments in equities. Research in capital markets has shown that
investments in equities/stocks generally exceed investments in government bonds,
particularly in terms of long-run returns. In practice, the risk premium of a specific 'market
portfolio' can be approximated on the basis of empirical studies of historic market risk
premia. The application of historic market risk premia assumes that in the long-run, the
expected future average of annual market risk premia approximately equals the long-term
historic average.
19. Empirical studies are published by local institutions and/or researchers providing evidence
on historical market risk premia for various countries. Examples of recent studies
concerning the risk premia of different countries are:
•
Ibbotson Associates: annually published yearbooks, International Cost of Capital
Perspectives Report 2003 and other reports for international cost of capital analysis
(http://www.ibbotson.com/)
• Damodaran: "Country Default Spreads and Risk Premiums" and various other databases
(http://www.damodaran.com/)
• Dimson/Marsh/Staunton: "Triumph of the Optimist", Princeton University Press, 2002
20. Alternatively, it is possible to determine the market risk premium by our own calculation.
This calculation would be based on the historical long-term average return of government
bonds as opposed to shares extracted from Bloomberg or similar services. Given historic
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Calculation of risk-free rate of return (German example) 1. Assumptions Date 8. Mrz 05 Achtung!! Basisdaten nicht aktuell!!! Initial value 100 Growth rate p.a. 1,00% Reinvestment after 30 yrs at return rate of 7,00% (historical long-term average return) 2. Calculation Year 2005 2006 2007 2008 2009 ... 2034 2035 2035ff. Discounting period 1 2 3 4 5 ... 29 30 31 Return "Zero-Bonds German Government" 2,30 2,64 3,02 3,34 3,59 ... 5,15 5,16 7,00 Period cash flow 100 101 102,01 103,03 104,06 ... 132,13 133,45 134,78 Present value return "Zero-Bonds German Government" 97,76 95,88 93,29 90,33 87,22 ... 30,83 29,50 404,73 Accumulated present value 2.179,04 3. Conversion of annual returns of government bonds into "constant" rate of return "Terminal" period cash flow 100 Present value return "Zero-Bonds German Government" 2.179,04 "Constant" return to derive present value 5,59% (conversion of perpertuity formula, q.v. section 11.4) Risk-free rate of return 5,59%
returns for a preferably wide share index as well as an index representing a broad portfolio
of government bonds, you would be able to calculate a long-term average return of each of
the indices. The market risk premium by definition is derived by deducting the average
return of the shares index from the average return of the portfolio of government bonds.
Beta factor
21. The Beta factor representing the specific risk (non-diversifiable risk) of an investment is
needed to weight the market risk premium. In valuation practice, historic Beta values for
those stocks listed at a stock exchange are commonly used. This information is available
through financial sources such as Bloomberg, Reuters or the financial press. If a company
is not listed at the stock exchange, Beta factors need to be determined by calculating an
average Beta-factor of a peer group of companies active in the same or at least a
comparable field of business. Subjective judgement has a relatively strong impact on the
Beta value as no clear-cut, strictly objective criteria exists on how to compile a peer-group.
It should be noted that even the calculation of the Beta factor of a listed company is subject
to a certain degree of bias due to different possible modes of calculation (eg different
relative indices, different periods of time for calculation, etc).
22. Beta factors as presented by financial information systems or the financial press are
usually calculated by linear regression of observed market returns relative to the
presentation of a specific market portfolio, such as a share index. In practice, the Beta-
factor is often derived on a weekly basis for a past period of 24 months. A period of this
length is useful because a relatively broad data base is offered and a sufficient number of
current values are implied. Longer time periods, such as five years, can also be used to
estimate Beta factors because these longer estimates flatten the fluctuations of Betas over
the business-cycle. This tends to be more efficient in terms of lower standard deviations,
but also may imply the risk of distortion due to structural changes in the stock price
development. The use of historical Beta-factors on a weekly basis has become a rather
accepted standard in practice (eg standard settings of Bloomberg extract weekly data).
The decision about periodicity as well as the period of length to be considered when
deriving Beta factors is an issue of subjectivity in any particular valuation. For risk
management procedures and quality standards, we should ensure that the underlying
calculation of the applicable Beta factor for any valuation assignment is justifiable.
23. By definition, Beta factors depend on the underlying relative market portfolio (eg share
index). In practice, the market portfolio of the business to be valued is commonly
represented by a wide and well-established local or regional share index (eg S&P500, FT-
SE 100, Dow Jones Stoxx 600, Hang Seng, SandP/ASX 200), that is seen to be a close
proxy of the market portfolio.
24. The following two examples of Beta-calculations for Telefonica S.A./Spain were provided
by Bloomberg. As you can see, the choice of the reliable market portfolio (Example 1:
IBEX 35, which is a local share index, Example 2: DJ STOXX 50, which is an European
index) has a major impact to the result of the Beta-calculation (Example 1: Raw Beta =
1,32; Example 2: Raw Beta = 0,93)
25. Example 1:
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26. Example 2:
27. In practice, not all businesses to be valued are quoted on a stock exchange. The Beta-
factors of publicly traded companies may be judged unreliable due to restricted trading
volumes, heavy speculative implications or other factors influencing stock price
movements. In these cases, the Beta factor should be derived by means of identifying a
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member firms are not a worldwide partnership. GTIL and each member firm is a separate legal entity. Services
are delivered independently by the member firms. GTIL does not provide services to clients. GTIL and its
member firms are not agents of, and do not obligate, one another and are not liable for one another’s acts or
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peer group. The reliability of a company's Beta factor can be evaluated by assessing the
trading volume relative to the market capitalisation and/or a measure of statistical quality as
represented by the correlation of the stock price relative to the index (R2).
28. A peer group generally comprises companies active in the same or at least a comparable
field of business. Again, financial sources, especially Bloomberg, provide ready data on
companies of the same industry. Even though peer groups may be provided at the push of
a button from financial information resources, care must be taken not to copy them blindly.
You should still take time to assess the statistical quality of the data and its comparability to
the business being valued.
29. Within international peer groups, the different underlying local share indices used to
represent the market portfolios should be comparable in terms of their significance and size
to the local markets.
30. To proceed properly according to financial theory, the Beta factors calculated for each
member of the peer-group may be adjusted ('unlevering' or 'ungearing') by their individual
financing structure, at least if apparent differences occur to the financing structure of the
business being valued. It is worth considering weighing the resulting ungeared Beta
factors of the peer group by their correlation to the market portfolio. This will enable you to
take into account the statistical quality in calculating the average value. It is particularly
important to do this in cases where the peer group is composed of a majority of companies
only trading with thin volumes at the stock exchange. Subsequently, the weighted average
of the ungeared Beta factors of the peer-group should again be adjusted for the finance
structure ('relevering') of the business to be valued.
31. At the end of any Beta assessment, the valuer should always ensure that the Beta factor
for the business being valued is sensible in the context of qualitative risk considerations.
Calculation of the terminal value from perpetuity
(relevant for DCF/earnings-based approaches only)
32. The terminal value of a constant stream of cash flows throughout perpetuity is calculated
by the following formula:
Present Value of constant CF = CF / Discount Rate
33. It should be noted that this formula gives the present value at the starting date of the CF
stream. For example, if the period of detailed forecast is five years, the formula gives the
terminal value of constant perpetual cash flows for the time beyond as at the end of the fifth
year. Therefore, it has to be discounted only for five years in order to obtain the present
value from today's standpoint.
Perpetual growth
34. When calculating the terminal value of a constant stream of cash flow throughout
perpetuity the question arises how to account for cash flow/ earning growth rates that can
be expected to be sustained throughout perpetuity.
35. Generally, it is assumed that the capital market return as represented by the cost of capital
includes an element that accounts for inflationary effects, which, to a large extent in the
medium term, follows the rate of inflation. This is not necessarily the case for company
cash flows/profits. Therefore, when comparing the capital market return and the return
from a company's cash flows, the different effects of inflation are to be accounted for.
36. The development of company cash flows depend on internal costs as well as on market
and competitive forces. Cost increases can either be compensated by rationalisation
schemes without profit decreases, or passed on to consumers in appropriate market
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conditions. They can however, also lead to profit decreases if they cannot be passed on or
if internal measures for reductions in costs are exhausted or not possible. In either case,
the valuer should be aware that profits do not always grow with inflation.
37. In practice, the valuer should assess whether a company is in a sustainable position to
pass its general price increases (at least partly) to its customers or if it is able to attain
sustainable growth.
38. The determination of perpetual growth rates overall differs depending on growth
perspectives and the competitive situation of the business to be valued. Applicable growth
rates may also be higher than inflation due to a very short detailed forecast period that
does not represent obvious potential for growth.
39. Once the perpetual growth rate has been determined it should be deducted from the (post-
tax) discount rate. This technically accounts for an increase of the terminal value by the
assumed growth rate. The discount rate lowered by the perpetual growth rate serves as
the appropriate discount rate with which to calculate the terminal value of constantly
growing perpetual cash flows.
40. The terminal value often represents well over half or two thirds of the net present value of
future cash flows, and is also at least partly attributable to the assigned perpetual growth
rate hence great care should be taken in its determination. Wherever possible, appraisal of
a company's perpetual growth rate should be cross-checked with similar valuation cases.
Compilation of data on market values of comparative companies
(relevant for market-based approaches only)
41. The availability of data on market prices and key financial figures of comparable
businesses is critical to the Comparative Company approach as a method for determining
market values of a business. The following sources of information may be used in order to
obtain this data:
•
•
•
•
information on current market capitalisation and current key financial data of comparable
listed companies which is available through the internet, the financial press or specialised
financial sources such as Bloomberg or Reuters.
studies and other publications on M&A transactions in certain industries
professional databases on relevant M&A data. Please note that Grant Thornton maintains
its own database on transaction data. For enquiries please contact John Morgan in the
GTI advisory team. The service is free of charge.
individual databases on market values of companies within recent transactions that are
available locally
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member firms are not a worldwide partnership. GTIL and each member firm is a separate legal entity. Services
are delivered independently by the member firms. GTIL does not provide services to clients. GTIL and its
member firms are not agents of, and do not obligate, one another and are not liable for one another’s acts or
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